the small-business contracts handbook
DESCRIPTION
Whether your small business is a one-person home business or a larger business with employees and office space, contracts are central to the business. How well do you understand them? Most contracts tend to be written with lots of obscure legal phrases. Not understanding what, exactly, you are agreeing to when you sign a contract can be a really expensive mistake.The Small-Business Contracts Handbook explains the clauses and conditions found in most business contracts in plain English, tells you what to look out for, and helps you cut through the legalese to what the contract is really saying. This sample includes the table of contents and initial chapter of the book.TRANSCRIPT
THE SMALL-
BUSINESSCONTRACTSHANDBOOKUnderstand, Negotiate, and Avoid Problems
• Avoid expensive legal fees • Leverage contract provisions to your advantage
Lawrence Hsieh, Attorney at Law
L E G A L S E R I E S
CD-ROM included
Publishersof high-quality,
low-cost legal
information at an
affordable priceSince 1971
Save time and avoid problems!
Small businesses have to deal with contracts on a regular basis, but unfortunately most small businesses don’t have in-house lawyers to ensure that contracts are fair,
or to create new contracts when necessary.The Small-Business Contracts Handbook helps small-
business owners to understand hundreds of standard contract clauses, such as those found in partnership agreements, lease agreements, and contracts for purchase or sale of goods or of a business.
Using everyday language, attorney and author Lawrence Hsieh takes readers step-by-step through standard clauses and explains their meanings. He pinpoints potential problems in contracts, and clarifi es legal jargon in simple terms for the layperson.
While it takes a great deal of hard work to make a small business successful, it can also come down to paperwork. A well-written contract can make or break a business. Having a
CD-ROM includes:
• Hundreds of must-have sample clauses for small-business contracts
• Simple tips to get the most out of your negotiations
• Essential links to associations, resources, reference materials, and websites
SYSTEM REQUIREMENTS: • Microsoft Windows 95, 98, ME, 2000, XP, Vista, 7, or NT4• MS Word or compatible software• CD-ROM drive• Web browser: IE Version 7 or similar
good understanding of standard business contracts and being able to negotiate and make changes to your own are critical skills essential to the effective running of a small business.
The CD-ROM included with this book can be installed on any Windows-based PC, and contains resources for the small-business owner, extra content, and sample contract clauses in PDF format.
About the authorLawrence Hsieh is an attorney with his own corporate law practice and is a member of the New York Bar. He is a graduate of the University of Chicago Law School and Cornell. His website is www.contractadviser.com.
www.self-counsel.com
EA
N
Legal
$29.95 USDISBN 978-1-55180-856-7
Lawrence Hsieh
THE SMALL-BUSINESS CONTRACTS HANDBOOK
THE SMALL-BUSINESSCONTRACTS HANDBOOK
prelim.qxp 3/9/2010 4:49 PM Page i
Self-Counsel Press(a division of)
International Self-Counsel Press Ltd.USA Canada
THE SMALL-BUSINESSCONTRACTS HANDBOOK
Lawrence Hsieh, Attorney at Law
prelim.qxp 3/9/2010 4:49 PM Page iii
Copyright © 2010 by International Self-Counsel Press Ltd.
All rights reserved.
No part of this book may be reproduced or transmitted in any form by any means —graphic, electronic, or mechanical — without permission in writing from the publisher,except by a reviewer who may quote brief passages in a review.
Self-Counsel Press acknowledges the financial support of the Government of Canadathrough the Book Publishing Industry Development Program (BPIDP) for our publish-ing activities.
Printed in Canada.
First edition: 2010
Library and Archives Canada Cataloguing in Publication
Hsieh, Lawrence, 1962-Business contracts handbook / Lawrence Hsieh.
ISBN 978-1-55180-856-7
1. Contracts — United States. 2. Small business — Law and legislation —United States. 3. Business law — United States. I. Title.
KF889.H84 2010 346.7302 C2009-905078-1
Inside ImageCopyright©iStockphoto/businessman writing on a form/denisenko
Self-Counsel Press(a division of)
International Self-Counsel Press Ltd.
1704 North State Street 1481 Charlotte RoadBellingham, WA 98225 North Vancouver, BC V7J 1H1
USA Canada
prelim.qxp 3/9/2010 4:49 PM Page iv
Introduction xviii
Part I — CORPORATE STRUCTURES 1
1 Business Entity Selection 3Overview 3Entity Selection 3
2 Organizational Documents 7Overview 7Sample Contract Excerpts 8
Certificate of incorporation/LLC certificate of formation — business purpose 8Certificate of incorporation — authorized number of shares 8Preemptive rights 9Bylaws 9Certificate of incorporation and/or bylaws 11
3 Shareholder Agreements and LLC Operating Agreements 14Overview 14Sample Contract Excerpts 15
Shareholder agreement/LLC operating agreement transfer restriction 15Right of first refusal — to the company only 16Right of first refusal — to the company and then the
other shareholders/members 18Drag-along rights 21Tag-along rights 23Status of ownership upon death — no sale 23
CONTENTS
v
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vi The Small-Business Contracts Handbook
Status of ownership upon death — mandatory sale 24Other Sale or No Sale Triggering Events 25
Transferees subject to agreement 26Preemptive rights 27Non-competition 28Additional capital contributions 28Owner loans 29Owner voting 29
Part II — BASIC CORPORATE TRANSACTIONS 31
4 Sale of Goods 33Overview 33The law governing the sale of goods 36What about international sales contracts? 37Sample Contract Excerpts 38
Principal obligations 38Price 41Payment terms 42Quantity 47Delivery terms 48Acceptance of goods; claims for damage, shortfall, etc. 50Appointment of distributor; territory/customer restrictions —
distribution agreements only 51Other provisions relating to the appointment of a distributor 53Minimum purchase quantity — primarily found in distribution agreements 58Warranties 59Intellectual property — seller’s ownership 63Intellectual property — infringement 64Liability cap 65No consequential damages 66Insurance 66Termination 69Non-competition — primarily found in distribution agreements 70
5 Sale of Services 72Overview 72Sample Contract Excerpts 75
Principal obligations — service agreement 75Principal obligations — sales representative agreement 76Service fee/compensation — flat fee 76Service fee/compensation — percent commission
(sales representative agreement) 78Late payments/set-off 82Appointment of sales representative territory/customer restrictions 82
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Contents vii
Independent contractor status 83Other provisions relating to the appointment of a sales representative 85Termination 88Non-competition 90Claims of service provider — liability cap and no consequential damages 91Compliance with laws 92Indemnity 92
6 Non-Disclosure Agreements (NDAs) 94Overview 94Key Provisions of Confidentiality Agreements 98Sample Contract Excerpts 100
Principal obligations 100Confidentiality 100Non-use 100Need-to-know exception 101Court-ordered disclosure exception 101Definition of confidential information 102Information types 103Information formats 104Exceptions to definition of confidential information 105Exceptions to exceptions 106Patents versus trade secrets 106Term of confidentiality agreement 107Return of confidential information 108No obligation to enter into transaction 109
Part III — BUYING OR SELLING A BUSINESS 111
7 Structuring the Deal 113Overview 113Due Diligence 114Due Diligence Checklist 116
Contracts — full force and effect analysis 116Contracts — restrictions on transfer/purchase 117Encumbrances 118Environmental 119Litigation and government investigations 120Incentive compensation/retirement plans 120Health benefit plans 122Intellectual property 122
Letter of Intent 124Legal Structure of Sale of Business 125Asset versus Stock Sale 126
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viii The Small-Business Contracts Handbook
Asset sale 126Liabilities of the business assumed by the purchaser in an asset transaction 127Stock sale 127Tax impact 128Allocation of purchase price 130Incentive compensation/retirement plans 131Collective bargaining obligations 131Intellectual property 133
Key Provisions of Sale of Business Agreements 133Summary of key provisions 133
8 Principal Obligations of the Buyer and Seller 136Overview 136Sample Contract Excerpts 137
9 Corporate Assets Purchased 139Overview 139Sample Contract Excerpts 140
Assets (to be sold) 140Asset categories 141Equipment (and other personal property) 142Inventory 143Accounts receivable 144Real property 144Fixtures 145Contracts 145Warranties 146Personal property leases 146Intellectual property 147Permits 148Records 148Prepaid expenses 149Goodwill 149Excluded assets 149Cash 150Certain contracts 150Corporate entity documents/items 150Insider loans 150Tax rights 151Unliquidated claims 151APA 151
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Contents ix
10 Corporate Obligations Assumed 152Overview 152Sample Contract Excerpts 152
No obligations/liabilities assumed 152Seller’s conduct 153Seller’s default 153Alternative — certain obligations assumed 153Seller’s accounts payable 153Obligations under assigned contracts 153
11 Purchase Price and Payment Terms 154Overview 154Sample Contract Excerpts 154
Cash at closing 154Alternative — deferred payment 155Alternative (APA) — cash plus assumption of liabilities 156Allocation of SPA purchase price to individual selling stockholders 156Earnouts (APA and SPA) 157
12 The Closing 160Overview 160Sample Contract Excerpts 160
Closing — time and place 160Seller deliveries at closing (APA or SPA) 160Ancillary documents 161Officer and director — ancillary documents 163Contract consents 165Government consents 165Legal opinion 166Resolutions 166Purchaser deliveries at closing (APA or SPA) 167Purchase price 167Ancillary documents 167Resolutions 168
13 Representations and Warranties of the Seller 169Overview 169
How to qualify representations 170Sample Contract Excerpts 173
Survival of representations 173APA introductory language 177SPA introductory language 178
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x The Small-Business Contracts Handbook
Organization, power, and authority to run business 178Qualification in foreign jurisdictions 180Authority to sell 180Consent of third parties to transaction 181Consent of government authorities to transaction 183No conflict with corporate documents, contracts, or laws 183No liens resulting from transaction 184Enforceability 184Capitalization 185Financial statements 186No material adverse change 188Extraordinary transactions or events (generally) 189Litigation and investigations 191Undisclosed liabilities (other than taxes) 192Taxes 193Compliance with law 194Environmental 195Assets 196Title to assets — balance sheet 199Sufficiency and condition of assets 199Inventory 200Accounts receivable 201Contracts 202Intellectual property 203Real estate 204Employee benefit plans 206Labor matters 208No brokers 209Brokers — alternative 210Full disclosure 210Sandbagging 212
14 Representations and Warranties of the Buyer 214Overview 214Sample Contract Excerpts 215
Organization; power and authority to run business 215Authority to buy 215Enforceability 215Securities laws 215
15 Affirmative Covenants and Negative Covenants 217Overview 217Sample Contract Excerpts 217
Access 217
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Contents xi
Consummation of agreement 218Conduct of business 219Notice of changes 220
16 Closing Conditions 221Overview 221
Closing conditions of the purchaser 221Sample Contract Excerpts 222
Representations and warranties — “bring down” 223Compliance with covenants 224No legal and government action 225Contract consents 225Government consents 225Ancillary documents 226Financing 226Other documents/actions 227Additional closing conditions to consider 227Closing conditions of the seller 228Representations and warranties 229Compliance with covenants and no legal and government action 229
17 Indemnity 230Overview 230
Termination 230Close, but recover post-closing 230Renegotiate and then close 231Mutual indemnities 232
Sample Contract Excerpts 232
Part IV — LOANS 233
18 Types of Business Loans 235Overview 235Promissory notes 236Lines of Credit 237Term Loans 238Revolving Loans 239
19 Loan Payment Issues 242Overview 242Sample Contract Excerpts 243
Advances — term loan 243Advances — revolving credit facility 243Fixed interest 244Floating interest — alternative 245Default interest — fixed rate loan 246
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xii The Small-Business Contracts Handbook
Default interest — floating rate loan 247Usury 247Payments — term loan 248Prepayments — optional — term loan 248Prepayments — mandatory 250Prepayments — mandatory — revolving borrowing base 250Commitment fee — revolving credit facility 251Facility fee — revolving credit facility or term loan 251Closing fee — revolving credit facility or term loan 252Defaults and events of default — revolving credit facility or term loan 252Event of default remedies — revolving credit facility or term loan 256
20 Representations, Warranties, and Covenants 257Overview 257Contract Clause Discussion 258
Organization; power and authority to run business; and qualification in foreign jurisdictions 258
Authority to enter into the loan transaction (i.e., borrow the money and enter into the loan agreement, promissory note, etc.) 258
Consent of third parties to transaction; consent of government authorities to transaction; no conflict with corporate documents, contracts, or laws 258
Enforceability 259Financial statements 259No material adverse change 260Undisclosed liabilities (other than taxes) 260Litigation and investigations 260Compliance with laws 261List of assets; title to assets; sufficiency and condition of assets 261Full disclosure (a.k.a., 10b-5 representation) 261Covenants 262
Sample Contract Excerpts 265Introductory language (covenants) 265Affirmative covenants 266Negative covenants 273Financial covenants 280
21 Guaranties 287Overview 287Sample Contract Excerpts 288
The guaranty 288Absolute, unconditional, and irrevocable liability of the guarantor 289Guaranty of payment (versus collection) 290Continuing guaranty 290Waivers of defenses 291
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Contents xiii
Reinstatement 295
Part V — STANDARD CONTRACT CLAUSES 297
22 Boilerplate in General 299Overview 299
23 Termination 301Overview 301Sample Contract Excerpts 302
Termination for cause (breach) 302Termination for cause (bankruptcy) 303Termination for cause (death or disability) 304Termination for cause (assignment) 305Termination for convenience 305
24 Remedies and Limitation of Liability 306Overview 306
Remedies quick primer 306Sample Contract Excerpts 308
Cumulative remedies 308Exclusive remedies 309Liquidated damages 310Exclusion of consequential and incidental damages 310Liability cap 311Availability of equitable remedies 311
25 Severability 312Overview 312Sample Contract Excerpts 313
Alternative 1 — Offending provision severed 313Alternative 2 — Severable to extent determined by court 313Alternative 3 — Not severable 313
Alternative Severability Clause for Non-Compete Provisions 314
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Laws are constantly changing. Every effort is made to keep this publication as cur-rent as possible. However, the author, the publisher, and the vendor of this bookmake no representations or warranties regarding the outcome or the use to whichthe information in this book is put and are not assuming any liability for any claims,losses, or damages arising out of the use of this book. The reader should not rely onthe author or publisher of this book for any professional advice. Please be sure thatyou have the most recent edition.
NOTICE TO READERS
xv
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xvii
I would like to express my deepest appreciation to Richard Day, publisher at Self-Counsel Press, for sharing my vision on this project, and to Managing Editor EileenVelthuis and her team for their expert guidance. It’s been a pleasure to work withall of you.
About the Author: Lawrence Hsieh is a corporate attorney in Connecticut. Hegraduated from the University of Chicago Law School and Cornell University.Please visit Lawrence’s law blog at http://contractadvisor.com/blog.
ACKNOWLEDGMENTS
acknow.qxp 3/9/2010 4:50 PM Page xvii
To my all-star team; wife Janice, and children Jennifer and Jason, who amaze and inspire me every day.
Thank you to Janice, and to my mom and dad, for believing in me.
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xxi
The Small-Business Contracts Handbook is a resource of first resort to help you, thesmall-business person and entrepreneur, understand and negotiate a wide variety oflegal provisions found in common business contracts. The marketplace is filled witha dizzying array of legal resources, including good books and websites that offer do-it-yourself contract forms for non-lawyers, as well as highly technical treatises andbooks on the finer points of contract drafting for practicing attorneys and law stu-dents. But it occurred to me a few years ago that there are very few resources thatactually break down and explain the meaning of common contract provisions (bothdeal-point and boilerplate) in a way that savvy businesspeople without formal legaltraining would find useful in their contract negotiations. Enter The Small-BusinessContracts Handbook.
Non-lawyers are often bewildered by the legal jargon contained in business con-tracts. I add value by presenting ideas, concepts, and facts that are common knowl-edge to and used every day by experienced practicing attorneys, but in plain English,in a way that is easy for non-lawyers to understand. This book will arm you with theknow-how to enable you to effectively negotiate your transactions, as well as workand communicate more efficiently with your attorney.
While I explain the meaning of many individual contract provisions, I’ve chosennot to include any complete contract “forms” in the book. Many small businessespurchase or download complete contract forms and use them without careful con-sideration of all the issues. This one-size-fits-all approach can be dangerous becausethere are at least two parties with different interests in every business transaction.Furthermore, forms are often passed down from deal to deal and from attorney toattorney. So you may think you’re starting off with a bulletproof form (advantageous
INTRODUCTION
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to you) when in fact, the form may contain provisions that are very much againstyour best interests, or in some other way significantly watered down or ambiguousin a way that can harm you.
I will present individual contract provisions (organized by topic), explain theirmeaning, and offer commonly accepted ways that attorneys leverage the provisionsto their advantage.
Chapters include sections on corporate infrastructure (including contract pro-visions found in shareholder agreements and LLC operating agreements), businesstransactions (including contract provisions found in agreements for the sale ofgoods and services, asset purchase and stock purchase agreements for the sale of abusiness, non-disclosure agreements to protect confidential information, loanagreements, etc.), and contract boilerplate (including contracts provisions found atthe end of just about every business contract).
If you have any questions or comments, I invite you to visit my blog, the Con-tract Adviser, located at http://contractadviser.com/blog.
xxii The Small-Business Contracts Handbook
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Part ICORPORATE
STRUCTURES
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OVERVIEWMost readers will already be familiar with the different types of business entities, aswell as basic formation documents like a corporation’s certificate of incorporationand bylaws. There are plenty of good resources, including free resources on the In-ternet, comparing the pros and cons of forming one type of entity versus another; forexample, a corporation versus a Limited Liability Company (LLC), as well as companies and websites offering the basic formation documents and forms for sale orfor free.
While I include a summary of these basic issues in this chapter, I devote thebulk of this section to explaining contract provisions found in the agreements gov-erning the legal relationship between the owners of business entities — the LLCOperating Agreement, and its corporate cousin, the Shareholder Agreement (a.k.a.,Stockholder Agreement).
ENTITY SELECTIONThe Entity Selection Chart (Table 1) contains basic information comparing the fiveprincipal forms of small-business ownership with respect to formation and owner-ship, liability of owners for business obligations, availability of pass-through taxa-tion, and management/authority to sign contracts. Consult with your attorney andtax advisor on your particular situation, including the availability of methods to con-vert from one form of business ownership to another.
1BUSINESS ENTITY
SELECTION
3
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4 The Small-Business Contracts Handbook
TABL
E 1:
Ent
ity
Sele
ctio
n Ch
art
Form
of b
usin
ess
owne
rshi
pC
Cor
pora
tion
S C
orpo
ratio
nLi
mite
d Li
abili
ty C
ompa
ny(L
LC)
Lim
ited
Part
ners
hip
Sole
Pro
prie
tors
hip/
Gen
eral
Par
tner
ship
Form
atio
n/O
wne
rshi
pA
corp
orat
ion
is a
bus
ines
sen
tity
form
ed b
y fil
ing
a ce
rtific
ate
of in
corp
orat
ion
(or e
quiv
alen
tdo
cum
ent)
with
the
stat
e’s
secr
etar
y of
sta
te. F
or fe
dera
lin
com
e ta
x pu
rpos
es,
corp
orat
ions
are
“C c
orpo
ratio
ns”
by d
efau
lt (p
ass-
thro
ugh
tax
not
avai
labl
e –
see
disc
ussi
on b
elow
).Th
e ow
ners
are
refe
rred
to a
ssh
areh
olde
rs o
r sto
ckho
lder
s.
A Su
bcha
pter
S co
rpor
atio
n is
aco
rpor
atio
n th
at e
lect
spa
ss-th
roug
h in
com
e ta
xtre
atm
ent b
y fil
ing
IRS
For
m25
53 (E
lect
ion
by a
Sm
all
Bus
ines
s C
orpo
ratio
n).
A lim
ited
liabi
lity
com
pany
(LLC
) is
a bu
sine
ss e
ntity
form
ed b
y fil
ing
a ce
rtific
ate
ofor
gani
zatio
n (o
r equ
ival
ent
docu
men
t) w
ith th
e st
ate’
sse
cret
ary
of s
tate
. An
LLC
is a
hybr
id e
ntity
that
offe
rs li
mite
dlia
bilit
y to
its
owne
rs (r
efer
red
toas
mem
bers
), lik
e a
corp
orat
ion,
and
pass
-thro
ugh
inco
me
taxa
tion,
like
a p
artn
ersh
ipor
pro
prie
tors
hip.
A lim
ited
part
ners
hip
is a
pass
-thro
ugh
busi
ness
ent
ityw
ith tw
o cl
asse
sof
ow
ners
. The
owne
rs c
onsi
stof
at l
east
one
gene
ral p
artn
er,
and
at le
ast o
nelim
ited
part
ner.
A so
le p
ropr
ieto
rshi
pis
a b
usin
ess
owne
dan
d op
erat
ed d
irect
lyby
one
per
son,
but
not
thro
ugh
a bu
sine
ssen
tity.
A ge
nera
l par
tner
ship
is a
bus
ines
s ow
ned
and
oper
ated
by
at le
ast
two
peop
le, b
ut n
otth
roug
h a
busi
ness
entit
y.M
inim
um(o
r max
imum
,if
appl
icab
le)
num
ber o
f ow
ners
At l
east
one
sha
reho
lder
.A
t lea
st o
ne s
hare
hold
er,
but a
n S
cor
pora
tion
cann
otha
ve m
ore
than
100
shar
ehol
ders
. Th
ey m
ust
be n
atur
al p
erso
n U
.S.
citiz
ens
or re
side
nts.
At l
east
one
mem
ber.
Mem
bers
can
be U
.S. o
r for
eign
nat
ural
pers
ons
or b
usin
ess
entit
ies.
At l
east
one
gene
ral p
artn
er a
ndon
e lim
ited
partn
er.
A s
ole
prop
rieto
rshi
p by
defin
ition
has
one
owne
r. A
gen
eral
partn
ersh
ip m
ust h
ave
at le
ast t
wo
owne
rs.
Liab
ility
of o
wne
rsTh
e ow
ners
(sha
reho
lder
s) h
ave
limite
d lia
bilit
y fo
r the
obl
igat
ions
of th
e bu
sine
ss. T
his
mea
ns th
atth
e sh
areh
olde
rs a
re li
able
for
the
debt
s of
the
busi
ness
onl
y up
to th
e am
ount
of t
heir
capi
tal
cont
ribut
ions
. Onc
e th
at m
oney
isgo
ne fr
om th
e co
rpor
atio
n an
d if
ther
e ar
e no
oth
er c
orpo
rate
asse
ts, t
hen
the
cred
itors
can
not
go a
fter t
he s
hare
hold
ers’
pers
onal
ass
ets.
Cre
dito
rs,
how
ever
, can
hol
d sh
areh
olde
rspe
rson
ally
liab
le fo
r bus
ines
sob
ligat
ions
if th
e sh
areh
olde
rs ru
nth
e bu
sine
ss “p
erso
nally
” and
not
thro
ugh
the
corp
orat
ion,
for
exam
ple,
by
not k
eepi
ng s
epar
ate
corp
orat
e re
cord
s, c
omin
glin
gco
rpor
ate
and
pers
onal
fund
s or
asse
ts, o
r chr
onic
ally
and
sev
erel
yun
derc
apita
lizin
g th
e co
mpa
ny.
Bas
ical
ly, i
f the
sha
reho
lder
sdi
sreg
ard
the
corp
orat
ion,
so
too
will
a c
ourt
whe
n cr
edito
rs s
eek
com
pens
atio
n w
hen
the
com
pany
is in
solv
ent.
An
S c
orpo
ratio
n el
ectio
ndo
es n
ot im
pact
the
limite
dlia
bilit
y of
the
shar
ehol
ders
.S
cor
pora
tion
shar
ehol
ders
have
the
sam
e lim
ited
liabi
lity
enjo
yed
by C
corp
orat
ion
shar
ehol
ders
,su
bjec
t to
the
sam
eex
cept
ions
.
The
owne
rs (m
embe
rs) h
ave
the
sam
e lim
ited
liabi
lity
asth
at e
njoy
ed b
y co
rpor
ate
shar
ehol
ders
, sub
ject
to th
esa
me
exce
ptio
ns.
The
gene
ral
partn
ers
are
join
tlyan
d se
vera
lly li
able
for t
he o
blig
atio
nsof
the
busi
ness
.P
rovi
ded
the
limite
d pa
rtner
s do
not p
artic
ipat
e in
man
agem
ent,
they
have
the
sam
elim
ited
liabi
lity
asth
at e
njoy
ed b
yco
rpor
ate
shar
ehol
ders
.
A s
ole
prop
rieto
r is
pers
onal
ly li
able
for
the
oblig
atio
ns o
f the
busi
ness
. The
gen
eral
partn
ers
are
join
tly a
ndse
vera
lly li
able
for t
heob
ligat
ions
of t
hebu
sine
ss.
chapter 1.qxp 3/9/2010 4:55 PM Page 4
Business Entity Selection 5
Liab
ility
of
owne
rsco
ntinue
d
A s
hare
hold
er is
als
o pe
rson
ally
liabl
e if,
am
ong
othe
r act
s, h
e or
she
com
mits
frau
d on
beh
alf o
f the
corp
orat
ion,
inju
res
som
ebod
y (a
tort)
whi
le a
ctin
g on
beh
alf o
f the
corp
orat
ion,
or a
ffirm
ativ
ely
guar
ante
es th
e co
rpor
atio
n's
oblig
atio
ns. T
he la
st a
ct, o
f sig
ning
a gu
aran
tee,
is a
way
of s
igni
ngaw
ay a
sha
reho
lder
's li
mite
d lia
bilit
yby
con
tract
.A
vaila
bilit
y of
pass
-thro
ugh
taxa
tion
The
defa
ult r
ule
for c
orpo
ratio
ns is
two-
tiere
d ta
xatio
n. C
cor
pora
tions
mus
t pay
inco
me
tax
on th
eir p
rofit
s.If
the
corp
orat
ion
mak
es a
div
iden
ddi
strib
utio
n of
its
prof
its, t
hen
that
prof
it is
taxe
d ag
ain
to th
esh
areh
olde
rs. S
mal
l bus
ines
s C
corp
orat
ions
typi
cally
avo
id th
is“d
oubl
e ta
x” im
pact
by
payi
ng it
ssh
areh
olde
rs s
alar
y an
d bo
nus
(whi
ch a
re d
educ
tible
exp
ense
s),
rath
er th
an d
ivid
ends
(whi
ch a
reno
t).
The
shar
ehol
ders
mus
taf
firm
ativ
ely
elec
t pas
s-th
roug
h ta
x tr
eatm
ent
(i.e.
, Sub
chap
ter S
sta
tus)
by fi
ling
IRS
For
m 2
553
(Ele
ctio
n by
a S
mal
lB
usin
ess
Cor
pora
tion)
.Th
is w
ill e
nabl
e ea
chsh
areh
olde
r to
repo
rt hi
s or
her s
hare
of t
he b
usin
ess’
prof
its (a
nd lo
sses
) on
his
or h
er p
erso
nal i
ncom
e ta
xre
turn
, eve
n if
the
shar
ehol
der d
oesn
't ta
kean
y pr
ofits
out
of t
hebu
sine
ss.
The
defa
ult r
ule
for L
LCs
ispa
ss-th
roug
h ta
xatio
n (s
ee n
ext
para
grap
h) –
eac
h m
embe
rre
ports
his
or h
er s
hare
of t
hebu
sine
ss' p
rofit
s (a
nd lo
sses
) on
his
or h
er p
erso
nal i
ncom
e ta
xre
turn
, eve
n if
the
mem
ber
does
n't t
ake
any
prof
its o
ut o
f the
busi
ness
. “C
heck
the
Box
” Rul
es–
The
Inte
rnal
Rev
enue
Ser
vice
clas
sifie
s LL
Cs
for t
ax p
urpo
ses
as a
cor
pora
tion,
par
tner
ship
or
sole
pro
prie
tors
hip.
A m
ulti-
mem
ber L
LC is
trea
ted
by d
efau
ltas
a p
artn
ersh
ip fo
r inc
ome
tax
purp
oses
(pas
s-th
roug
h ta
xatio
n)un
less
it e
lect
s to
be
treat
ed a
s a
corp
orat
ion
for i
ncom
e ta
xpu
rpos
es b
y fil
ing
IRS
For
m 8
832,
Ent
ity C
lass
ifica
tion
Ele
ctio
n.. A
sing
le-m
embe
r LLC
is tr
eate
d by
defa
ult a
s a
sole
pro
prie
tors
hip
(“di
sreg
arde
d en
tity”
with
pas
s-th
roug
h ta
xatio
n) u
nles
s th
eow
ner e
lect
s co
rpor
ate
inco
me
tax
treat
men
t by
filin
g Fo
rm 8
832.
The
defa
ult r
ule
for
part
ners
hips
ispa
ss-th
roug
hta
xatio
n. E
ach
partn
er re
ports
his
or h
er s
hare
of t
hebu
sine
ss’ p
rofit
s (a
ndlo
sses
) on
his
or h
erpe
rson
al in
com
e ta
xre
turn
, eve
n if
the
partn
er d
oesn
't ta
kean
y pr
ofits
out
of t
hebu
sine
ss.
The
defa
ult r
ule
for s
ole
prop
rieto
rshi
psan
d pa
rtne
rshi
psis
pas
s-th
roug
hta
xatio
n. E
ach
owne
r rep
orts
his
or h
er s
hare
of t
hebu
sine
ss’ p
rofit
s (a
ndlo
sses
) on
his
or h
erpe
rson
al in
com
e ta
xre
turn
, eve
n if
the
owne
r doe
sn't
take
any
prof
its o
ut o
f the
busi
ness
.
Man
agem
ent/
Aut
horit
y to
Sig
nC
ontr
acts
Cor
pora
tions
are
man
aged
und
erth
e di
rect
ion
of th
e bo
ard
ofdi
rect
ors.
Offi
cers
, who
are
ele
cted
by th
e di
rect
ors,
hav
e da
y-to
-day
man
agem
ent a
utho
rity,
and
can
sign
con
tract
s on
beh
alf o
f the
corp
orat
ion.
Sam
e as
C c
orpo
ratio
n.LL
Cs
can
be m
embe
r man
aged
(man
aged
equ
ally
by
the
owne
rs)
or m
anag
er m
anag
ed (m
anag
edby
the
desi
gnat
ed o
wne
rs o
r thi
rdpa
rty, s
imila
r to
the
way
aco
rpor
atio
n w
ould
be
man
aged
).Th
e m
anag
ers
can
sign
con
tract
son
beh
alf o
f the
cor
pora
tion.
Lim
ited
Partn
ersh
ips
are
man
aged
by
the
gene
ral p
artn
er.
Gen
eral
par
tner
sca
n si
gn c
ontra
cts
onbe
half
of th
e bu
sine
ss.
Lim
ited
partn
ers
enjo
ylim
ited
liabi
lity
if th
eydo
not
par
ticip
ate
inm
anag
emen
t.
The
owne
rs m
anag
eth
e bu
sine
ss, a
ndca
n si
gn (o
rde
sign
ate
offic
ers
who
can
sig
n)co
ntra
cts
on b
ehal
fof
the
busi
ness
.
chapter 1.qxp 3/9/2010 4:55 PM Page 5
DBA stands for “Doing Business As.” If a sole proprietor, corporation, or anyother business entity wishes to conduct business under any name other thanhis, her, or the business’s legal name, then he, she, or it must register its fic-titious or assumed name with the respective state’s secretary of state.
Keep in mind that only legal persons (individuals or business entities like corpora-tions, LLCs, etc.), may enter into business contracts. A DBA is not a legal entity. Sowhen a business with a DBA enters into a contract, it should sign the contract as“[Legal Name] DBA [Ficticious Name].”
6 The Small-Business Contracts Handbook
chapter 1.qxp 3/9/2010 4:55 PM Page 6
OVERVIEWThis chapter will discuss selected provisions contained in a corporation or LimitedLiability Company’s (LLC) formation documents. These include a corporation’scertificate of incorporation (or equivalent document), and an LLC’s certificate oforganization (or equivalent document). These certificates are filed with the secre-tary of state in the state in which the corporation or LLC is formed.
For small corporations, the certificate of incorporation is a relatively short doc-ument, typically one to two pages long, because small businesses usually only needto issue one class of common stock. If the corporation plans to issue more than oneclass of stock, then the certificate will be quite a bit longer because it needs to setforth in some detail the relative rights and preferences of the different classes ofstock (see the Capital Stock Quick Primer later in this chapter). The certificate of incorporation will contain provisions listing the name and address of the corpo-ration, as well as the name and address of the registered agent who is authorized toreceive service of process on behalf of the corporation in a lawsuit.
A corporation’s bylaws is a private document that is not filed with the secretaryof state. While the bylaws establish ground rules for corporate governance (e.g.,conduct of shareholder and board meetings, voting, etc.), the bylaws are not a sub-stitute for a well-drafted shareholder agreement. For example, “buy-sell” provi-sions, which establish the rights and obligations of the shareholders when one ofthem dies, becomes disabled, or wants to transfer shares, are beyond the scope ofthe bylaws, and typically are found in shareholder agreements (see Chapter 3 formore about shareholder agreements).
2ORGANIZATIONAL
DOCUMENTS
7
Org
chapter 2.qxp 3/9/2010 4:55 PM Page 7
An LLC is formed by filing a short certificate of organization, but does not havebylaws. Rather, LLC members may enter into a contract called an operating agreement (state law sometimes makes this optional) that contains not only basicbylaw-type provisions dealing with general governance, but also buy-sell and othershareholder agreement provisions. Shareholder agreements and operating agree-ments are discussed in more detail in Chapter 3.
SAMPLE CONTRACT EXCERPTSCertificate of Incorporation/LLC Certificate of Formation —Business Purpose
The purpose of the Company is to engage in any lawful act or activity for which corpo-rations [limited liability companies] may be organized under the [insert name of appli-cable law, for example, General Corporation Law of State of Delaware], as amended fromtime to time, or any successor thereto.
For most small businesses, it’s enough to include something similar to this generalpurpose provision. In fact, a more detailed purpose provision could hamstring yourexpansion efforts down the road. Consult with your attorney if you are forming acorporation (typically a Professional Corporation or PC) to engage in professionalpractice, like law, in which case the certificate of incorporation will need to includea more detailed description of the business purpose. Note that I use the term “Com-pany” thoughout the book for consistency. The term “corporation” is typically usedto describe the Company in the certificate of incorporation and bylaws.
Certificate of Incorporation — Authorized Number of Shares
The total number of shares of capital stock that the Company is authorized to issue is[insert number] shares of common stock, without par value.
The authorized number of shares is the maximum number of shares the corporationcan issue. See the Capital Stock Quick Primer later in this chapter for a discussionof frequently used terminology such as authorized, issued, outstanding and treasuryshares. Consult with your attorney on the optimal number of authorized shares inyour state — the optimal number of authorized shares is often the maximum num-ber of shares you can authorize while paying the minimum incorporation fees, whichwill vary by state.
8 The Small-Business Contracts Handbook
chapter 2.qxp 3/9/2010 4:55 PM Page 8
Organizational Documents 9
What Is Par Value?
Par value is the nominal dollar amount assigned by the corporation to a classof stock. Consult with your attorney as to whether your state mandates or givesa choice of designating par or no par stock. For small businesses issuing onlycommon stock, the notion of par is somewhat dated — shares typically are is-sued for an amount necessary to adequately capitalize the company, which isusually much greater than the nominal par amount.
Preemptive Rights
No preemptive rights exist with respect to shares of capital stock or securities convert-ible into or exchangable for shares of capital stock of the Company, whether now orhereafter authorized or issued.
If the Company is free to issue shares to whomever it wants, it will dilute the own-ership of the existing shareholders. Preemptive rights help the existing shareholdersmaintain their proportionate ownership (and therefore voting power, right to prof-its, etc.) by entitling the existing shareholders (typically common shareholders) theright to purchase newly issued shares of stock (or securities convertible into sharesof stock) before they are offered to third parties. However, such provisions mayplace the Company at a disadvantage when seeking third party equity financing togrow the Company. Consult with your attorney and financial advisor on whetherpreemptive rights are appropriate for your situation. State law varies, so consultwith your attorney on whether preemptive rights are automatically granted or de-nied, or must be affirmatively provided for or denied in the company’s certificate ofincorporation. Note that preemptive rights can also be granted by contract, and maybe provided for in the company’s shareholder agreement or operating agreement.
BylawsShareholder Vote — Majority versus Plurality
The election of directors is determined by a plurality of the votes cast at a meeting ofShareholders at which the number of Shareholders representing a quorum is present inperson or by proxy.
chapter 2.qxp 3/9/2010 4:55 PM Page 9
10 The Small-Business Contracts Handbook
A majority is a situation where over half of the votes are cast for one of usually twochoices, whether regarding a vote on a specific issue or the election of directors. Aplurality is useful in situations when there are at least three choices (like the provi-sion presented here for the election of directors), and is defined as a situation whereone choice receives more votes than any of the other choices.
Shareholder Vote — Cumulative Voting
At all elections of directors duly called and held, each Shareholder entitled to vote hasthe right to cast as many votes as are equal to the product of the number of
(i) directors to be elected and
(ii) shares owned by such Shareholder. Such Shareholder may cast all such votes for asingle director or may distribute them among any two or more of them in any man-ner as he or she may see fit, and the directors receiving a plurality of the votes castshall be elected.
There are two main voting systems for the election of board members. Let’s look atan example — a hair salon business owned by Harry Cutter, Manny Cure, Buzz Bar-bur, and Aldo Stiles. If they form a corporation with each person owning 25 sharesof common stock and a board of four directors, then the outcome of the board elec-tions could differ depending on whether the corporation’s bylaws call for statutoryor cumulative voting.
In either statutory or cumulative voting, each shareholder would be entitled toone vote per share for each vacant board seat. So in this example, each shareholderwould have 100 votes (25 shares multiplied by the four vacant board seats). The dif-ference between statutory and cumulative voting is how each shareholder is able toallocate his or her total number of votes.
In statutory voting, which typically controls if the bylaws are silent, each share-holder in the example can only vote up to 25 shares for any one candidate. The likelyoutcome in a non-dysfunctional business would be that the four shareholders wouldend up filling the four board seats. Statutory voting favors large shareholders — ifHarry owned 51 out of the 100 issued and outstanding shares, he would control who fillseach board position, including the ability to bring in an outside director of his choosing.
In cumulative voting (see sample contract provision above), however, eachshareholder would be entitled to vote his 100 shares any way he or she liked. Theshareholder could allocate 25 votes to each of the four candidates, all 100 shares tojust one candidate (and not vote for anybody else), or any allocation in between. Cu-mulative voting helps minority shareholders with fewer votes be able to combinevotes to vote for their most favored candidates.
chapter 2.qxp 3/9/2010 4:55 PM Page 10
Organizational Documents 11
Certificate of Incorporation and/or BylawsExculpation of Personal Liability of Directors
A director or officer of the Company shall not be liable to the Company or its Share-holders for breach of fiduciary duty, except to the extent that exculpation from liabilityis not permitted under applicable law in effect at the time such liability is determined.No amendment or repeal of this paragraph applies to or has any effect on the liabilityor alleged liability of any director or officer of the Company with respect to any acts oromissions of such director or officer occurring prior to such amendment or repeal.
Consult with your attorney about the extent to which your state corporate law allowsthe Company to include exculpatory provisions in the certificate of incorporationthat limit or eliminate the personal liability of directors (or even officers, employ-ees, and agents) to the Company or shareholders for damages arising from acts un-dertaken by such persons on behalf of the Company. Companies often includeexculpation (and indemnification provisions, discussed below) in their charter doc-uments to enable them to recruit and retain management. For smaller companieswhose shareholders also run the business, these provisions provide yet another layerof personal asset protection.
The sample provision works to insulate the directors from personal liability foracts undertaken on behalf of the Company. Keep in mind, however, that these pro-visions don’t work to protect the directors from personal liability for a director’s in-tentional misconduct, illegal behavior, reckless acts, or omissions, as well as adirector’s involvement or approval of any deal in which the director gained an im-proper personal benefit (called Improper Behavior).
Indemnification of Directors
(a) To the fullest extent permitted by law, the Company shall indemnify, hold harmless,and defend (“indemnification”) any person (an “Indemnified Party”) who is or wasa party or is threatened to be made a party to any threatened, pending or com-pleted claim, demand, action, suit, or proceeding, whether formal or informal, civil,criminal, administrative, or investigative (the “Action(s)”), by reason of the factthat such person is or was or has agreed to be a director or officer of the Company,from and against any and all damages, losses, and liabilities incurred by such per-son, including, but not limited to, [reasonable] attorney fees and expenses, judg-ments, fines, penalties, and amounts paid in settlement incurred in connection withany such Action.
Indemnification provisions work hand-in-hand with exculpation provisions (dis-cussed above) to limit or eliminate the personal liability of the directors for acts un-dertaken on behalf of the Company. Subsection (a) provides the basic frameworkfor the Company’s indemnification of past and present directors in the widest rangeof proceedings.
chapter 2.qxp 3/9/2010 4:55 PM Page 11
12 The Small-Business Contracts Handbook
The provision can also be drafted to include the provisional advancement of lit-igation expenses such as attorney fees to a director pending the resolution of the Ac-tion. Since the advance is provisional, the Company advances the funds regardlessof the director’s behavior. If it’s later determined that indemnification is appropri-ate, the advance merely becomes part of what would have had to be indemnifiedanyway. If it’s later determined that indemnification is not appropriate (for exam-ple, because of improper behavior), then the director has to return the advance.
(b) Notwithstanding anything herein to the contrary, no indemnification shall be madeunder subsection (a) above to the extent a judgment or other final adjudication es-tablishes that the Indemnified Party
(i) engaged in fraudulent or intentional misconduct or a knowing violation of law,that was material to the Action, or
(ii) personally gained a financial profit or other advantage to which he or she wasnot legally entitled.
(c) Notwithstanding anything herein to the contrary, no indemnification shall be madeunder subsection (a) above for any Action initiated by an Indemnified Party unlesssuch Action (or part thereof) was brought to enforce the Indemnified Party’s rightsto indemnification hereunder.
Subsection (b) works to disqualify Improper Behavior from the right to indemnifi-cation. In the sample contract provision, indemnification is limited to the defense ofActions; Subsection (c) excludes an Indemnified Party’s counterclaims from indem-nification.
(d) Such indemnification is not exclusive of other indemnification rights arising underany agreement, Director or Shareholder consent, or otherwise. No amendment or re-peal of this paragraph shall affect any indemnification of any director or officer ofthe Company with respect to any acts or omissions of such director or officer oc-curring prior to such amendment or repeal.
Despite the general statutory authority to include indemnification provisions, theenforceability of these provisions is the subject of much litigation. Hence, the caselaw in this area is constantly shifting, for example, relating to the indemnification ofpast directors for acts or omissions that took place before the Company amendedits certificate of incorporation or bylaws to eliminate the indemnification provision.Subsection (d) is meant to address this issue, but it may be better for the director toalso enter into an indemnification contract with the Company; contracts generallycannot be “amended or repealed” without each party’s (including the director’s)consent.
chapter 2.qxp 3/9/2010 4:55 PM Page 12
Organizational Documents 13
Capital Stock Quick Primer
Ownership in a corporation is represented by shares of capital stock. Capitalstock consists of common stock and preferred stock. Most small businessesissue only common stock, which typically conveys full voting rights. Preferredstockholders have a prior claim (before common stockholders) on dividendsand the assets upon dissolution. Preferred stockholders may have limited vot-ing rights. Then there are the various calls, options, puts, rights, warrants, orother “securities” that entitle the holder to obtain shares of capital stock con-vertible at some future date or based on some other triggering (financial orother) event.
The certificate of incorporation will list the types, as well as the number,of shares (and other “securities”) the corporation is authorized to issue. Theauthorized number of shares is the maximum number of shares the corporationcan issue. It’s a good idea to issue just a portion of the shares. If a corpora-tion has 1,000 authorized shares, and issues 250 shares to Tom and 250 sharesto Josie, then the company has issued 500 shares, with the balance of theshares deemed “unissued shares.” Unissued shares have no impact on percent-age ownership. In other words, Tom and Josie each own 50 percent of the com-pany. Think of unissued shares as shares that are held in reserve until thecorporation needs to issue more shares. If a corporation issues all of its shares,then if it needs to issue more shares at a later date, it’ll have to engage in thetime-consuming and relatively expensive task of amending the certificate of in-corporation to authorize the additional shares.
Once Tom and Josie pay the company for the shares, then the shares aredeemed to be fully paid and non-assessable. If at a later date, the company re-purchases some of Tom’s or Josie’s shares, and then the company holds suchshares, it is deemed to hold on to them in the form of treasury stock. Tom andJosie own issued and outstanding shares. Treasury Stock is deemed to be is-sued shares, but not outstanding shares. If the company decides to repurchaseand then retire the shares, then the shares revert back to being authorized butunissued shares.
It’s a little confusing, so remember these formulas:
Authorized Shares = Issued Shares + Unissued Shares
Issued Shares = Outstanding Shares + Treasury Shares
Therefore: Authorized Shares = Outstanding Shares + Treasury Shares + Unissued Shares
chapter 2.qxp 3/9/2010 4:55 PM Page 13