Ethan Zook writes:

As was alluded to in a prior blog post, one of the major changes that has been enacted through Pennsylvania’s Act 170 is the ability, through the operating agreement, to contractually vary fiduciary duties of members and managers in Pennsylvania limited liability companies.

What Fiduciary Duties?

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There are two major fiduciary duties to be aware of: the duty of care and the duty of loyalty. The fiduciary duty of loyalty is comprised of five subsections which can be summarized as follows:

  1. account to the company and hold as trustee for it any property, profit or benefit derived in the conduct or winding up of the company’s activities;
  2. do not use the company’s property for personal gain;
  3. do not appropriate a company opportunity for personal gain;
  4. refrain from engaging in self-dealing with the company; and
  5. refrain from competing with the company in the conduct of the company’s activities and affairs.

The duty of care is to refrain from engaging in gross negligence, recklessness, willful misconduct or knowing violation of law. Lastly, there is an obligation of good faith and fair dealing to be aware of, however, it is not a fiduciary duty.  Rather, it is treated as a contractual obligation, and as will be discussed, can be contractually altered by the operating agreement.

A member of a member-managed limited liability company owes to the company and the other members the fiduciary duties of loyalty and care. Managers of manager-managed limited liability companies owe to the company and the members those same duties.

Contracting Around Fiduciary Duties

The Act gives tremendous deference to the operating agreement, the main governing document for Pennsylvania limited liability companies.  If not manifestly unreasonable, the operating agreement may alter subsections 1), 2), and 4) of the duty of loyalty stated above.  Subsections 3) and 5) can be eliminated altogether.  Further, if not manifestly unreasonable, the operating agreement may also identify types of activities that do not violate the duty of loyalty, may freely alter the duty of care, and may prescribe the standards by with the performance of the contractual obligation of good faith and fair dealing is to be measured. Any other fiduciary duty can be altered or eliminated though the operating agreement, if not manifestly unreasonable.

Manifestly Unreasonable?

In any dispute regarding the reasonableness of the terms of the operating agreement, courts will decide whether those terms are manifestly unreasonable as a matter of law. That determination will be made as of the time the challenged term became part of the operating agreement by considering circumstances existing only at such time. This does not shed much light on what will be considered manifestly unreasonable under the terms of the Act. Instead, for now, we are left with intuition in deciding what is manifestly unreasonable.

Despite the ambiguity surrounding “manifestly unreasonable”, the Act makes it clear what fiduciary duties can be altered and eliminated. With that, it has become more important than ever to review the operating agreements of investment, potential partner, and current parent and subsidiary companies to see how loyal that company has chosen to be to itself and its members.


Ethan Zook is an associate in the firm’s Corporate Department, resident in its Exton office.

Issuers and investors are well advised to document their deal in a term sheet.  Though generally non-binding, they add significant value.  Detailed term sheets raise issues early when there is still ample negotiating time. They also make drafting the definitive documents more efficient, saving on legal fees. However, parties must be vigilant to document the deal properly, especially when using terms of art.

Cumulative dividends
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For example, one commonly negotiated item on preferred stock is the dividend. Dividends can be cumulative (aka accruing) and either simple or compounding. The terms “cumulative” and “compounding” are sometimes (incorrectly) used interchangeably. But the differences are measurable in real dollars. 

Dividends are one feature that makes preferred stock preferable. Dividends are structured in (at least) three common ways. NVCA publishes a sample term sheet that includes these options.

  1. Dividends can be paid on the preferred when (and if) they are paid on the common. The preferred holders have no dividend preference – they are treated as common holders and paid as if converted to common.
  2. Dividends can be paid on the preferred when (and if) declared by the Board of Directors. If the Board does not declare dividends, they are forfeited.  Here, the preferred holders enjoy a preference on dividends but may not receive them.
  3. Finally, as described in detail below, dividends can be cumulative and perhaps even compounding.

Cumulative vs. Compounding

Emerging companies rarely have the ability to pay dividends to preferred holders. As a solution, companies often agree to pay dividends upon a liquidity event (e.g., sale of the company).  But how much will investors receive? This is where the terms of art (cumulative, accruing, compounding, simple) become very important.

Cumulative (aka accruing) dividends provide investors with a certain annual return, typically expressed as a percentage of the original per share price of the preferred stock (e.g., “8% of the Series A Original Issue Price”).  Thus, the term “cumulative” refers to the fact that dividends accrue over the years and will be paid upon a liquidity event.

Cumulative dividends can be calculated on a simple or compounding basis.  “Simple” means the dividend is based only on the original per share price.  “Compounding” means the dividend is based on the original per share price plus the dividends that accrue over time.  Thus, the terms cumulative and simple refer to how cumulative dividends are computed.

For example:

Cumulative and Simple (aka Non-Compounding):

Suppose an investor invests $50,000 and receives 100,000 shares of preferred stock ($0.50 per share) with an annual 8% cumulative, simple dividend. In 5 years, the company is sold. The 8% annual dividend is calculated on the original per share price. The investor has earned $4,000 in dividends each year and, upon liquidation, the company must pay the investor $20,000 in dividends.

Cumulative and Compounding:

Suppose the same facts, but dividends are now cumulative and compounding. The 8% annual dividend will be calculated on the original per share price and on the accrued and unpaid annual dividends that accumulate over the years. This is similar to a promissory note with compound interest: the original per share price is like “principal” and the 8% annual dividend is like a compounding 8% interest rate. In this scenario, the investor earns $23,466.40 in dividends.

Clearly, there is a measurable difference between simple and compound dividends. And at first glance, the $3,466.40 difference may not seem overly significant. But the proper use of term sheet terminology has a greater value. A detailed and thoughtful term sheet helps maintain deal flow and good will during negotiations, can decrease legal fees and helps avoid disputes down the road.  For issuers and investors at the outset of a long friendship, these benefits can be immeasurable.

As mentioned in the first post of this series, the goal of many entrepreneurs is to seek venture capital financing or ultimately sell their company in an “exit” merger or acquisition. Upon making representations and warranties (which are essentially, assurances) associated with any of these transactions, the seller opens itself up to risk. If these assurances turn out to be false or are breached, the seller is subject to suit for breach of contract. Often, however, the parties negotiate an additional protection mechanism called indemnification.

So why is indemnification expected?

Puzzle pieces representing mergers & acquisitions
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In a traditional acquisition, the seller affirmatively agrees to indemnify the buyer for damages or costs related to various things; most notably, breach of a representation or warranty. The seller agrees upfront to hold harmless and to reimburse the buyer for any and all expenses related to their breach. For example, if the seller represented that its equipment was in working condition and it turns out it was not, the seller must make the buyer whole. Essentially, the seller is insuring the buyer on its purchase. Just like an insurance policy, this agreement to insure lasts for a certain period and covers certain events. As this creates ongoing obligations and future potential liabilities for the indemnifying party, the indemnification provisions in transaction documents, and particularly the scope and extent thereof, are often heavily negotiated and should be approached with extreme caution.

There are many protections that can be built into indemnification provisions and transaction documents that limit the scope of the seller’s liability beyond simply excluding scenarios which are covered. For example, the seller may agree to indemnify the buyer but only:

  • when the damages or costs exceed a certain amount in the aggregate (what’s known as a “basket”);
  • when the damages or costs exceed a certain amount for a particular claim (a “mini basket”);
  • in the aggregate up to the purchase price or some other set number (a “cap”); and/or
  • for a set period of time from Closing (the “indemnification period”).

Takeaway

In the transactional context, indemnification serves as the enforcement of representations and warranties. A buyer can truly rely on the seller’s representations if the seller has also agreed to hold harmless and reimburse the buyer if the representations are false or breached. The seller can effectively affirm the value of its business, but in doing so exposes itself to risk as a de facto insurer. As this is generally unavoidable in the context of a transaction, limiting the scope of this risk is key for sellers. For these reasons, indemnification provisions should be approached and drafted with extreme caution.

On Friday, May 12th, ransomware known as WannaCry (also known as WannaCrypt or WCry) spread throughout the world, affecting more than 100,000 systems in 150 countries. Victims of the massive cyberattack included the NHS in the UK, cellular networks in Spain, universities in China and many other large organizations worldwide. For entrepreneurs who are dependent on Windows systems to run their companies, the attack highlights the significant risks and high costs associated with keeping cybersecurity on the back burner.

Fox partner Mark McCreary provided an update on the attack yesterday on the firm’s Privacy Compliance and Data Security blog, and reflected on its impact after addressing client concerns on Friday and over the weekend.

Whether it is expanding into a new market or moving out of the proverbial garage, it is common for a startup company to sign a commercial lease agreement in its early stages. In negotiating the lease, the company’s legal counsel will rely heavily on the owner to advise on the “business terms” of the lease.  In fact, in many cases, the attorney is brought into the process after a letter of intent has been signed and the key business terms have been agreed upon.  These business terms are important and can be difficult to re-trade once they have been established with the landlord.  This post offers the following 5 tips for an owner negotiating the business terms of his or her first office lease:

  1. Personal Guaranty: The landlord may require a personal guaranty, particularly if the company has a limited operating history.  This can be a difficult pill to swallow, particularly for a business owner that has taken the proper steps to incorporate and shield himself or herself from individual liability.  If a personal guaranty can’t be avoided, try to limit the guaranty to a specified monetary amount (for example, the monthly rent multiplied by a certain number of months).  You could also propose eliminating the guaranty as of a future, specified date (provided that the tenant does not default under the lease prior to that date).
  2. Understand Your Additional Rent Obligations: A tenant’s “base rent” obligation is usually outlined clearly in the lease.  However, in many commercial leases, the tenant will owe additional amounts in excess of the base rent.  For example, taxes, insurance and/or maintenance expenses can be passed through to the tenant as an additional rent obligation in some leases.  While historical figures can provide a useful estimate of these expenses, they are not necessarily indicative of future charges.  Pay careful attention to how large capital expenses or major renovations can be passed on to your company.  Negotiating a cap on controllable operating expenses can be a useful way to limit the tenant’s exposure in this area.
  3. Permitted Use/Exclusive Use: Contact the local municipality to make sure that your contemplated use of the leased premises is permitted by applicable laws and zoning ordinances.  If you sign the lease and later learn that your desired use is not permitted, you may still be responsible for the entire lease obligation despite not being able to use the space for your business.  Also, if you are renting in a building or complex, consider requesting an exclusive use provision that limits the landlord’s ability to lease space to your competitors.
  4. Improvements/Alterations: If you need to make alterations or improvements to the space in order for it to meet your company’s needs, it can be helpful to negotiate and obtain approval for this work at the outset of the lease.  Often, a landlord will offer an allowance or free-rent period to assist a tenant with the initial fitout, but it is better to negotiate these concessions upfront than after the lease is signed.  In addition, the lease should clearly specify who owns the improvements and whether the tenant is required to restore the space to its original condition at the expiration of the lease.
  5. Have a Plan for Reducing or Expanding Space: It can be difficult for an early stage company to predict how much space it will need over a 3-5 year period (or longer).  Negotiating favorable parameters for assigning or subleasing the space can be extremely valuable if you ever need to downsize or exit the space.  Conversely, if you feel the space may eventually be too small, consider seeking a right of first option/refusal to lease other space at your building or complex.  This offers flexibility without requiring you to take on too much space before it is needed.
For lease sign
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For investors and founders of emerging tech companies, leaving money on the table is a tragedy which can never be remedied once it occurs. An exit sale to or investment from a large strategic buyer is for many young tech companies a once-in-a-lifetime event with enormous economic consequences impacting both the company’s founders and investors. They must “get it right” with respect to the enterprise value of the emerging tech company.

For reasons explained in a 2014 article by Fox Rothschild partner Mark V. Santo, the failure by the emerging tech company to conduct ‘reverse due diligence,” and undertake a deep dive into the operations and management of the acquirer, is tantamount to leaving money on the table.

On April 5, the Division of Corporate Finance of the Securities and Exchange Commission released two new compliance and disclosure interpretations (“C&DIs”) regarding Regulation Crowdfunding.  Regulation Crowdfunding was adopted in 2015 in order to implement the provisions of Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 that exempt certain crowdfunding transactions from registration under the Securities Act of 1933.

Crowdfunding
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The first new C&DI addresses the disclosure requirements of Rule 201, and specifically the related party disclosure requirements of Rule 201(r).  Rule 201(r) requires that in connection with a crowdfunding offering, a crowdfunding issuer must disclose and describe any related party transactions that are currently proposed or that occurred since the beginning of the issuer’s last fiscal year in which the amount involved is greater than 5% of the total amount that the issuer raised under the crowdfunding exemption over the previous 12 months, including the amount proposed to be raised in the current offering.

C&DI Question 201.02 clarified that for purposes of this requirement, crowdfunding issuers should calculate the 5% threshold for disclosure of related party transactions based on the target offering amount plus the amount already raised during the previous 12 months, even if the issuer indicates that it will accept offering proceeds in excess of the target offering amount. In other words, the possibility of accepting additional offering proceeds in excess of the target offering amount should be disregarded for purposes of calculating the 5% threshold for disclosure.

The second C&DI released by the Division of Corporate Finance clarifies Rule 202(b)(2), which provides that an issuer is no longer required to comply with the ongoing reporting requirements of Rule 202 once the issuer has filed at least one annual report pursuant to Rule 202 and has fewer than 300 shareholders of record.

C&DI Question 202.01 provides that, when calculating the number of shareholders of record for purposes of Rule 202(b)(2), the issuer is required to count all shareholders of the same class of securities issued in the crowdfunding offering, even if some of those shareholders did not obtain such securities in connection with the crowdfunding offering.

The full text of the two new C&DIs described above, along with all previously released C&DIs regarding Regulation Crowfunding, can be found on the SEC’s website.  In addition, an overview of the Regulation Crowdfunding rules can be found in this earlier Emerging Companies Insider post.

Under Section 3033 of the 21st Century Cures Act, a drug is eligible for regenerative medicine advanced therapy (“RMAT”) designation. To obtain this designation, the treatment must be “a cell therapy, therapeutic tissue engineering product, or any combination product using such therapies or products, “intended to “treat, modify, reverse, or cure a serious or life-threatening disease” and have preliminary clinical evidence that the drug has the potential to address unmet needs. In its Guidance for Industry entitled “Expedited Programs for Serious Conditions-Drugs and Biologics,” the FDA has defined its interpretation of whether a disease or condition is serious or life-threatening and whether a drug is intended to treat a serious disease or condition.

Copyright: kentoh / 123RF Stock Photo
Copyright: kentoh / 123RF Stock Photo

The RMAT designation provides an easier path to approval by lowering the bar for unmet medical need for serious or life-threatening diseases. The request for RMAT designation must be made either concurrently with submission of an Investigational New Drug (“IND”) application or as an amendment to an existing IND.  Additional data other than that required for an IND will not be required for a RMAT request.

This designation will provide additional resources from the FDA to expedite the approval process.  The agency will take an active role in assisting the applicant with advice during review.

Time will tell how well this provision is executed under the new law. For now, we have our first publicly disclosed RMAT designation for Humacyte and its product Humacyl, announced in March.

Robot Builder with Wrench
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A recent comment by Bill Gates that robots that take human jobs should “pay” taxes, or be taxed, has stirred debate in the artificial intelligence, economic and legal worlds. Numerous questions emerge from this debate, the most pertinent being who will actually be paying the tax. This may be solved by creating a legal entity for the robot to pay taxes, just as is done to tax corporations.

Many innovators in the emerging companies sector believe that automation, or at least partial automation, is inevitable in a capitalistic society, as we constantly strive for more efficient and accurate solutions.

Technology companies researching and developing robots have astronomically high costs, which is passed on to their customers, the businesses who purchase the robots. From an economic standpoint, a tax on the businesses for purchasing such robots is akin to a price increase, which lowers sales. If the companies sell fewer robots, it will be harder to justify their high initial investment in developing new technologies.  Overall, innovation in this sector could suffer if the robotic industry is burdened by heavy taxes.

Customers, on the other hand, simply will not see any of the savings inevitably reaped by businesses.  Assume a factory (or a restaurant, or customer service center) that is not automated employs 200 workers at $10 an hour (8 hours a day, 5 days a week, 52 weeks a year). This factory wishes to purchase “robots” to automate processes (an initial investment of up to millions of dollars) to decrease the burden of paying $4,160,000 in wages each year. This one time investment would bring their costs down and allow for lower prices. Most factories around the globe have already embraced this concept to some extent, and are not currently taxed for their automated processes. Any tax imposed on robots would narrow the savings gap that consumers would share in the form of lower prices.

On the other hand, if robots are taking over jobs ordinarily performed by humans, we could see a rise in unemployment and thus a corresponding drop in tax and social security payments made to the government. A tax on robots could help offset these losses.

Although robots have been replacing humans for years in many industries, the creation of more advanced robots has once again raised the question as to whether robots should be taxed like the humans they are replacing. Overall, despite the debatable philosophical standpoints on taxation, it is safe to say that there are consequences lying beneath the surface of such a proposed tax.

Once you have made the decision to incorporate your business, and gone through the formation process, it can feel like your company is ready to take on the world. However, there is one important item that cannot be neglected: the minute book. A minute book is the living official record of a business and contains all of the important documents to reflect the business’ history.

Checklist
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Maintaining organized records in a minute book is critical for any business.  For example, when a company seeks a new loan, raises funds via new investors, or becomes the target of an acquisition, it must undergo due diligence and produce its minutes to prove it has complied with both regulatory and its own self-governing documents such as its charter and bylaws.

The minute book begins with a business’ incorporation documents, including its articles of incorporation and bylaws (or articles of organization and operating agreement, if it’s an LLC). As time passes, and if the minute book is properly maintained, it will contain the documents that, among other things: authenticate compliance with governing documents via board and equity holder consents; confirm the company’s officers, directors and/or managers, who may resign or be replaced from time-to-time; and substantiate the capitalization of the company by memorializing changes in equity ownership.  Having a complete and current record streamlines any due diligence process and increases the company’s credibility from the very beginning.

Furthermore, the minute book will contain the “minutes” from the company’s annual and special board and equity holder meetings. The minutes are a written description of what took place at the meetings and serve to memorialize the actions taken by those in attendance during the meeting.  These records are valuable for preserving institutional memory, ensuring compliance with the company’s constitutional documents, and substantiating board or shareholder actions and processes if challenged later.

A corporation that commits to maintaining its minute book can save substantial time, money, and stress when it is called for review. On the other hand, neglecting to document the corporation’s history as it occurs can leave the company stuck trying to piece together years, if not decades, of information when the pressure is on to produce the records.