“What is a reverse merger or reverse IPO?”

Short answer: “reverse merger” is almost always spelled S-C-A-M.

There are a small handful of legitimate reasons why a non-scammy, non-scuzzy company would go through this process. It is expensive, provides little intrinsic value to the private company paying for everything, and does little else of note.

How is it structured?

Standard format: a private company enters into an agreement to merge with an existing listed (meaning on a stock exchange) company that has little or no assets, may have (preferably) gone through a bankruptcy to become a “clean shell,” and has existing stockholders whose shares probably have a fair market value of close to zero. These zombie companies may nevertheless have a stock price because of random trades, but the FMV is still close to zero. (You can do the math yourself, or just trust me.)

The merger goes through and the private company is merged into the public company with new shares issued to old private shareholders. The private company is thereby able to “take over” the securities filing status of the public company, meaning the private company is now effectively public (as if that matters!). In exchange, the shareholders of the shell get some amount of money, generally well into 6 figures (most of which will certainly go to fees for third-party advisors) and some percentage in the post-deal company (5-20% is not uncommon).

Why do people do these deals?

Because they think that now they can easily “raise money” that they couldn’t previously. Sort of true technically, but false on a practical level. Or, even worse, they think that because they’ve gone public, it magically comes with some kind of new capital. A full-form securities registration (S1) is expensive, and those companies still need brokers to sell the shares to investors. If you don’t spend the cash on the reverse merger, you could just look for underwriters to sell the shares in a regular IPO. Same result, cheaper, faster (since you don’t have to do the merger deal first), and without the equity haircut.

Are there legitimate reasons to do these deals if you’re the private company? Sure, there’s at least one: if you have an investor IN HAND who has ALREADY committed to investing but is subject to investment policy restrictions such as only investing in public companies, then the speed of getting from A to B via reverse merger might make sense. And in that scenario, the terms should be negotiated way, way down from the “typical” deal.

Bottom line?

In general, stay away and get advice from a reputable, experienced corporate/securities lawyer who has done mainstream deals before getting into this one.

Have any of you actually done one of these deals that made sense before or after? My suspicion is that it’s a null set. #FAIL

This one gets a #FAIL from me.

Hearkening back (or forward, since I don’t know if I’ve posted it yet) to my thoughts on why I write, one of them is definitely to signal to founders and directors of small and startup companies when they need to call a lawyer. I guess I’ll have to follow up soon with my hot-button post.

I think that it’s really useful for me to tell people when they absolutely need my advice (taking investment money of any kind), when I can almost certainly help (non-standard commercial contracts), when I can add value (helping negotiate a deal), and when I’m not helpful (picking colors for the website design). Honesty from me makes my clients more efficient, and I hope that it s’s more evidence to them and the not-yet clients that I fit their definition of “trusted.”

Here’s another LinkedIn-derived question that merits a better answer.

The question was essentially whether the fellow with some IP to build a business on should form an LLC or a corporation. In typical LinkedIn fashion, off-the-cuff answers that are specific end up being wrong. In my mind, if someone is asking this question, they either want a quick answer without worrying too much about whether it’s the right answer, in which case they might as well just phone a friend, or they want to understand *how* to make the decision.

As my readers have probably learned by now, I’m happy to educate clients on how to make decisions, on what factors to balance, and point them in the right direction on perceived issues that are just red herrings. At the end of the day, we all have to make our own decisions. Even if you decide to defer to a lawyer to make this sort of call, even if that lawyer is me, then you’ve decided to adopt (if only by proxy) my view of the world and my evidence to you that I understand your goals and plans well enough to make a recommendation that is right for you, just you, in your exact situation at this exact time and place. That’s what I do and how I do it.

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Dan, the answer to that question isn’t usually determined by just how you’ll exit but also who you may need (or want) as Investors and their requirements, the amount of capital your business plan requires, the timeline between here and there, and what the company will look like as it’s operating (the activities it undertakes, the risks it creates, the nature of the competition, and the underlying business model).

The business model is basically how you take capital from Investors, convert it into revenue and gross margin, and do those things at an SG&A level that leads to the generation of free cash flow.

So, in a nutshell, that’s the start of the analysis that I and other startup lawyers do when advising entrepreneurs. Not everyone belongs in a Delaware C-corp even though almost all Silicon Valley-style tech startups do.

I’ve linked two articles that will round this out a bit for you.
Good luck!

Links:

• Incorporate a tech startup
• Compare ownership structures

Does this treatment of pension “earnings” hold true at your companies, or have more interested boards at most companies cleaned this up? I support the use of free cash flow as the primary metric for executive compensation, although a detailed FCF analysis might give a board specific sub-targets for a C-level officer to achieve in pursuit of higher FCF. None of those, however, would be likely involve pension earnings or stock split numbers.

(On a related note, I was wondering whether seemingly “senseless” increases or decreases in pension plan earnings assumptions serve as an early indicator of operating and stock performance.)

In the course of forming a number of nonprofits as the lawyer on the team, I’ve seen the early stages of planning several times.

Most often, people think about what they want to do (mission) and how to approach the problem (strategy). They then turn to friends and colleagues to get a sense of whether the plan seems viable from both “will it work?” and “will people donate to this?” perspectives.

Then, depending on the plan, someone like me gets involved to talk about how to go about putting this activity into action (and here, the process parallels for for-profit process but with some different options thrown in the mix). What I’ve written elsewhere is that not everyone *needs* a new organization, and often times people take on new administrative burdens rather than starting their analysis from a “how best to solve the problem” perspective.

Moving back to the beginning, I’ve come to decide that the best way to go about this is to conduct a little thought exercise or scenario planning: imagine, and then work out with questions and details, what a day in the life of this as-yet-unformed organization looks like. What happens in the morning? Who is that person/people? Why are they there, what do they do? How do they get paid or compensated? Where does that money come from? Running through these sorts of questions further parallel the initial business planning process for traditional businesses, and help put things in perspective when it comes time to formalize a budget.

If you can describe the day-to-day operations of your organization in terms of the goal you have, the actions you take, what resources you will use and how you will acquire them, and the results you achieve, then you’ll be a lot further down the road to formalizing your plan when the time comes.

Where should I incorporate or form my entity?

After you’ve decided that it’s in your interest to form an entity of some kind, the next question is where to form that company. Most people know that Delaware is the 800-pound gorilla in this field. Many have also heard about privacy benefits of being incorporated in Nevada or wonder if they will be taxed differently depending on where the corporation “is.”

Here are the key questions:

1. Will you be realistically seeking venture financing?
2. Where are you located?

If the answer to #1 is yes, then your choice is probably limited to Delaware, with some ability to choose California if you’re there. Anywhere else, and you’re just going to have to reincorporate either shortly before or after the financing in any event. Venture capitalists see the selection of consistent corporate law as a way to easily reduce risk. (Here, it’s the risk of unknown laws leading to different results than they expect as well as the cost of finding a lawyer who knows Minnesota law or paying someone to learn it.) They’re right. Almost all good corporate lawyers have some familiarity with Delaware law, and it’s easy to find one if you need one. There are other reasons for choosing Delaware, but these apply to founders as well. My guess is that most of you will not have a lawyer who knows Nevada law easily accessible to you.

If you’re not looking for venture capital financing, and you basically run your business without any significant equity investors, then you should probably just incorporate where your business is located. You won’t pay the costs of being involved in two states, legal advice will be readily available, and those who interact with your business, such as bank lenders, will be familiar with the laws involved.

Sometimes people talk about “governing law.” In some cases they really mean state of incorporation, but some people mean the “choice of law” governing their contracts. It’s possible, through a “choice of law clause, to select a particular state’s law to apply to an agreement. Your goal is certainty of enforcement, meaning that a court will enforce a reasonable agreement as written rather than decide to “adjust” it for social policy reasons. Contracts, by their very purpose, are designed to supersede default state laws.

NY law is common in large commercial contracts, moreso than other states. You may, however, be likely to just choose local courts and local law if NY is inconvenient.

What do all these entities do?

This introduction will make it easier for you to come up with questions that will help you select the best alternative for your specific situation. There are almost always other issues that will come up if someone makes a three-year plan, for example. These issues could include financing, compensation, control (which doesn’t have to be the same as management or splitting profits), and long-term capital gains. Some other sticky issues involve getting someone out of the company, voluntarily or involuntarily, as well as a process for cashing out their interest. That question is partly answered by the corporate form you choose, but it can be modified by a separate agreement.

Partnerships

1. Partnerships fall into three general categories: general, limited, and limited liability partnerships. The third, the LLP, is usually reserved for professional firms such as law, accounting, or medical practice firms. It’s probably not relevant for most people. General partnerships are structures in which each partner is personally liable for all the debts of the partnership. That’s often not a good idea if the partners want to keep their house, etc. Limited partnerships, which protect the limited partners from personal liability, aren’t as good an option as they may seem in most cases because a general partner is still required. To prevent personal liability in this situation, an entity is usually the general partner. For most typical businesses, if you’re going to form an entity so you can use an LP, there’s little need to complicate the structure when the entity can simply own/run the business in the first place. The one advantage of a general partnership is that it requires no formalities to set up or administer except for an additional filing at tax time.

Verdict:

Not a great choice; last alternative unless there are special circumstances such as investment partnerships where the management is making investment decisions with the investor funds. Examples: real estate, venture capital, or hedge funds.

Corporation

2. The next choice to consider is a corporation. In part to achieve the substantially valuable goal of insulating shareholders from corporate liabilities, corporations require a fair amount of corporate formalities, including regular board and shareholder meetings, separate bank accounts, formal salaries, and separate tax returns. While the corporation can elect Subchapter S treatment, so that its income flows to the shareholders directly and is taxed on their returns, like a partnership, whether the added formalities are worth the effort depends on the size and structure of the business’s ownership. When outside investors are involved, a corporation becomes a better choice.

Also: depending on the size of the business, there may be tax advantages to the traditional corporation tax structure (which means regular corporate tax reporting). If the shareholders/managers want to load up on benefits, e.g., health care and retirement plans, through the business, it needs to be explicitly discussed with the accountants as well to confirm the specific requirements. However, even if they decide that corporate taxation is preferable, it is often possible to achieve the same results through an LLC.

Verdict:

Best choice when outside investors are involved. The difference between this outside money and that of an investment partnership is that investors in a corporation expect their money to be used by the corporation to pursue its business plan, not to make investments in other companies.

Limited Liability Companies

3. LLCs, or limited liability companies, are a hybrid form of corporate structure that combines the best aspects of partnerships and corporations with few of their disadvantages. It provides corporate-type insulation from personal liability for owners with the opportunity for pass-through taxation. Each owner of an LLC is called a member and if the formalities are observed (namely, LLC meetings, separation of business and personal funds, and sufficient capitalization or insurance to meet normal/expected liabilities), the members will not be personally liable for debts of the business. In terms of taxes, an LLC can choose to be taxed as a partnership or as a corporation. This provides a great deal of flexibility, especially if the members’ needs change over the course of the business.

Verdict:

Flexible entity that is expanding to cover most small businesses that used to be partnerships or sole proprietorships.

Finally, you should note that regardless of what corporate form you choose, if bank financing is required, for example, there is almost no way that a bank will lend money without personal guarantees and collateral. So, even though picking a different corporate form might protect against many of the debts of the company, perhaps the most substantial liabilities, at least in the beginning, are likely to remain with the principal individuals involved.

Here’s my edited answer:

As someone who’s represented dozens of startups, closed probably 100 venture deals, and cleaned up too many small companies to count, there is in fact a right way and wrong way to do this.

The best way, if you’re planning on a software company that will be seeking traditional VC money, is to form a Delaware corporation, taxed as a C-corp, that owns and develops the IP (the software). That structure works for VCs without creating problems.

Here are some quick points:

1. Using an S-corp or LLC taxed as a partnership means that there can be leftover tax liabilities. It’s not worth the trouble to diligence them, so you’ll just end up either killing the deal or hopefully putting the existing entity behind a chinese wall and having it be a shareholder in a new — yep, Delaware c-corp.
2. Profit sharing with employees can be done in many ways, but stock options are straightforward and well-understood both by VCs and software engineers. There’s a plethora of information available to everyone on how to value, structure, exercise, and pay tax(!) on them.
3. Ownership, management, and governance can be turned into sticky problems. Using a standard structure like the DE C-corp helps everyone focus on the actual issues instead of the wrapper.

The only realistic alternative, if you have substantial other income that could be sheltered and sufficient skills and funding to bootstrap for a while, would be to use one of the alternate structures (LLC w/partnership taxation) deliberately so as to harvest tax losses while you are developing to the point that you will seek VC funding and then execute the chinese wall maneuver I described earlier.

Think of it this way: it’s hard enough to have a great idea, start executing it, interest a VC, and close funding. Why would you let something like an uninformed legal entity structure jeopardize your deal? As you can tell, I’ve taken companies down several of these paths. Some are way better than others.

I’m onto a new startup idea.  How much would you charge to incorporate?  Do you have any advice as to where to incorporate?

Here’s my usual answer:

I’ve done this sort of work for companies under firm quotes of $2000 + state filing fees for a full incorporation package, including a lot of form documents necessary to engage new employees, issue stock to founders, etc. That includes my time advising on everything from the number of directors to how to divide up stock to what provisions founders need to protect themselves from each other.

In general, companies should incorporate in Delaware if they’re going to be venture-funded and have the extra money to lay out for administrative costs. That said, many, many companies in the Bay Area simply incorporate in California to reduce those expenses, particularly if they’re going to bootstrap for a while. VCs and other investors in the area are plenty familiar with California companies and don’t get bothered by it at all. What I would recommend against, in general, is incorporating anywhere else besides those two states. The costs will go up for regular compliance and administration, and you’ll only have to reincorporate later if you get funding.

To set up a charitable organization, you generally run through the following steps:

1. Determine whether you need an organization at all. The primary reason for the tactical step of forming a nonprofit is to collect donations from other people that (a) will not be taxable to the entity as income and (b) will be deductible by the donor. If your plan matches up with these desires, keep reading.

2. Determine whether your activities will constitute a “charitable purpose.” There are nonprofits that fall into different categories of charity that all for (a) but not (b) above.

3. Form an appropriate entity under state law (note: you don’t technically have to even form an entity in some states and can operate as an unincorporated association). Some states have a nonprofit corporation entity; in others you form a regular corporation and impose special rules in its articles or certificate of incorporation, sometimes referred to as its charter.

4. Make the appropriate IRS and state filings to secure your charitable status.

I have formed a number of nonprofits under various state laws. While having experience is useful when it comes to the corporate governance issues (the actual detailed language in the articles, bylaws, and corporate resolutions, most of the rest of Form 1023 is straightforward. You can probably do much of the work yourself if you like (see this Nolo resource article and the books they provide).