Reducing Legal Costs–Law Firm Personnel

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Entrepreneur: “Mr. Partner, we’ve decided to use your firm to represent us in our acquisition of XYZ company.”

Law Firm Partner: “Great!”

E: “Who do you propose should be on your team?  And why do you recommend them?  I’d really like to get your best mid-level associate, and would prefer not to use any first or second-year associates.  While I’m open to using young superstars, I really don’t want associates learning on my nickel.”

LFP: “OK, let me put together a proposal and get back to you.”

E: “Thanks!  And one more thing: once we’ve agreed on a team, I don’t want any personnel changes without my prior consent.”

LFP: “No problem.”

You don’t hire a law firm; you hire people who work for a law firm.  So it’s really important to have this kind of conversation at the outset of a matter.  You want knowledgeable, efficient, responsive attorneys working for you.  You don’t want associates learning at your expense, and you don’t want to be billed for getting new personnel up to speed in the middle of the engagement.  While partners will often proactively write off non-productive time, it’s been my experience that this does not always happen.  Since you probably don’t want to be spending your time scrutinizing law firm invoices and haggling with partners, try to avoid the problem in the first place by taking a real interest in who the firm assigns to your matter.  I’ve found that law firm partners are happy to have this conversation and are very reasonable in accomodating requests.

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Be Soft on the People, But Tough on the Issues

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“Be soft on the people, but tough on the issues.”  This is one of my favorite aphorisms, partly because it’s consistent with my values, partly because of its Zen-like simplicity, but mostly because I’ve found that it works.

When you’re dealing with a direct report, do you want them thinking “I’d do anything for my boss” or “If I don’t do what my boss wants, I’ll get fired”?  Do you want commitment, or compliance?  With the latter, you’ll probably get what you want, but not much more.  With the former, you could get substantially more than you ask for.  Do you want your employee to be energized, or anxious?  Peak performance studies (http://www NULL.amazon NULL.com/Mentally-Tough-Principles-Winning-Business/dp/0871315408/ref=sr_1_1?ie=UTF8&s=books&qid=1275602147&sr=1-1) pretty clearly indicate you should want the former.  You can take an interest in your employee’s family, and hold him or her accountable for meeting deliverables.  You can be compassionate and demanding.  They’re not mutually exclusive.

The same principle holds true for negotiations.  You don’t have to be a jerk in order to have a successful negotiation.  You can be friendly and respectful to the other party, and unyielding on the issues that are important to you.  In fact, the former may help you get the latter.  History is replete with examples where leaders’ personal rapport with each other enabled them to achieve negotiation breakthroughs.

Now, obviously there are exceptions and shades of grey.  Some employees respond better to pressure and some respond better to compassion.  And some negotiations are zero-sum, one-time transactions where the relationship is unimportant (for example, selling your car).  But, in general, I think it’s best to be soft on the people, but tough on the issues.

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Contracts: When the Other Party Provides the First Draft

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The suggestions in my last post assumed that you were providing the first draft of a contract.  What if the other party provides the first draft?  And what if, as may often be the case, the other party has more bargaining power than you do?

Here’s a suggested approach:

1.  Read the contract.  Or, if you’re pressed for time and/or “legalese” puts you to sleep, ask your attorney to identify the sections containing the key business terms.  Read those sections carefully, as you’ll understand your business goals better than your attorney does.

2.  Discuss with your attorney any concerns he or she has with the contract.  For each concern, ask: under what circumstances would this language come back to bite us?  What’s the probability of that occurring?  What would be the dollar downside to us?  Of course, these numbers will be purely speculative, but this exercise should enable you to identify those risks that have a high probability of occurring and/or a high dollar amount.  At the end of this process, your list of concerns will most likely be a lot shorter than the list your attorney brought to you.

3.  Negotiate key business terms directly with your counterpart at the other company.  Once the principals have agreed on the key business terms, the lawyers can negotiate the legal terms (e.g. indemnity, limitation of liability, reps and warranties, etc.) and less important business terms.  As a result of the risk analysis you did in Step #2, your attorney will enter that negotiation with a clear sense of what’s important to you and what’s not.

For how these negotiations should be conducted, see my post on “Negotiating a Transaction” or, better yet, read Fisher and Ury’s “Getting to Yes (http://en NULL.wikipedia NULL.org/wiki/Getting_to_YES).”

Thanks to Steve Blank (http://steveblank NULL.com/) for a recent post (http://steveblank NULL.com/2010/05/27/why-lawyers-don’t-run-startups/) that stimulated and clarified my thinking on this topic.

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How to Reduce Your Legal Fees (Post #1 in a Series)

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Client: “John, could you take a look at a contract that a potential partner sent over?”

John: “Sure.”

Fifteen minutes into reading the contract, I called my client and said something like “This is bull___t!  You’ve got some leverage in this relationship, yet this contract is so one-sided that there’s no way anyone in your position would sign it.  I could spend two hours revising it, which would probably result in a long negotiation with the other side.  Or I could spend 30 minutes preparing a form that’s balanced and that the other side could sign with very little negotiation.”  My client opted for the latter and got the deal done (a) quickly, (b) with very little in the way of legal fees, and (c) with terms that were completely acceptable.

The moral of the story: try to avoid one-sided first drafts of contracts, since their costs often exceed their benefits.  Of course, to the extent a party has significant bargaining power, it can negotiate for terms favorable to itself.  Nevertheless, (a) those negotiations cost money, (b) often the terms are a lot more important to the attorneys than they are to their clients, and (c) onerous terms may start a relationship off on the wrong foot and create incentives for cheating (this is a variant of the maxim “Leave something on the table”).  We have a small client that signed a deal with a VERY big and sophisticated company, and I was pleasantly surprised at how balanced the first draft of their contract was.  In retrospect, I shouldn’t have been surprised; they’re smart and they know how to use lawyers.

So, if you’re going to be producing the first draft of a contract, how balanced should it be?  If you don’t have significantly more bargaining power than the other party, instruct your attorney to prepare a draft that’s balanced and that the other side can sign with minimal negotiation.  If you’ve got a lot more bargaining power than the other party, decide which parts of the contract are most important to you and instruct your attorney to draft those sections with language that’s favorable to you without being unreasonable.  And then let your attorney get back to billing his or her hours to other clients.

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Entity Selection Simplified

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When starting a business, one of the first decisions you’ll need to make is what form of business entity to establish.  There’s lots of information on the Web re: the advantages and disadvantages of each entity type but, to my knowledge, nothing in the way of a methodology to help the reader actually make a decision.  So what follows is a simple algorithm to help you decide whether you should be a C corporation, S corporation, limited liability company, general partnership or sole proprietor.

Question #1: Will you be seeking venture capital funding?  If yes, you’ll want to be a C CORPORATION.  If no, go to Question #2.

Question #2: Will you be relying on options or equity to attract and retain employees and contractors?  If yes, you will want to be a CORPORATION and go to Question #3.  If no, go to Question #4.

Question #3: Do you want pass-through tax treatment?  If yes, you’ll want to be an S CORPORATION.  If no, you’ll want to be a C CORPORATION.  Caveat: S Corporations have several restrictions, such as (a) shareholders cannot be a corporation, a partnership or a non-resident alien, (b) there cannot be more than 100 shareholders, and (c) there cannot be more than one class of stock.

Question #4: Will you be seeking outside capital from any sources, or are you willing to pay approx. $2000 upfront and $800 annually (if you’re doing business in California) to achieve limited liability?  If yes, you will want to be a LIMITED LIABILITY COMPANY.  If no, go to Question #5.

Question #5: Are you going into business with others?  If yes, you’ll want to be a GENERAL PARTNERSHIP.  If no, you’ll want to be a SOLE PROPRIETORSHIP.

Rationale behind Question #1: VCs typically will only invest in C Corporations, because pass-through entities may produce unrelated business income that the tax-exempt limited partners of a VC fund do not want.

Rationale behind Question #2: Granting “profits interests” in LLCs is more complicated, and less understood by recipients, than granting options in corporations.

Rationale behind Question #3: S Corporations are taxed like partnerships i.e. only at the shareholder level.  So an S Corporation is particularly advantageous when (a) the corporation will be incurring losses and the shareholders have other income against which the losses can be deducted, or (b) the corporation will be paying dividends because it is generating (and not reinvesting) cash in excess of the cash compensation that will be paid to management.

Rationales behind Question #4: Investors typically want limited liability, so won’t invest in general partnerships or sole proprietorships.  LLCs are a great way to achieve limited liability without having to comply with corporate formalities, but have setup costs and, in California, are subject to an annual franchise tax of at least $800.

Like other discussions of the law that you’ll see on the Web, this one comes with the caveat that it consists of general principles only, and that there may be facts particular to your situation that would cause you to reach a different conclusion.  Nevertheless, you can use it as a first cut, and then refine your analysis to take into consideration additional factors.

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“Thrice Around the Block”

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Warning: this post contains promotional material!

One of our clients had an “aha” moment the other day.  He was describing accounts that his company had lost over the years, when my business partner asked: “What did all those accounts have in common?”  After pausing to think, the client said: “In each case where we lost an account, it was after a change in personnel, either at our company or at our customer.  Where we’ve retained accounts over the years, there’s been a continuity of personnel; those relationships have endured even though there have been product and service issues.”

This got me to thinking about the importance of relationships in business, and about a series of three blog posts (http://www NULL.thricearoundtheblock NULL.com/) that my business partner Ed Oh recently wrote about the sales process.  I’d like to quote from Ed’s post “Fear of Selling (http://www NULL.thricearoundtheblock NULL.com/2010/04/fear-of-selling NULL.html),” because I think it’s a nice distillation of the “business-as-relationship” concept:

“But what sometimes gets lost in all the press about Wall Street abuses is that good business is based on relationships, not transactions.  In fact, I would assert that it is when a business relationship shifts towards being purely transactional, that abuses flourish.  The fact that money changes hands in a business relationship shouldn’t negate the mutual benefits to be derived from that relationship…Just think about products or services that you’ve purchased that you’ve been happy with.  Did the fact that money was involved taint the relationship?  Or did you feel like you got a good value?”

Ed’s blog “Thrice Around the Block” (http://www NULL.thricearoundtheblock NULL.com/) is a great read for those of you interested in technology commercialization.  I especially recommend his post (http://www NULL.thricearoundtheblock NULL.com/2010/04/confident-selling NULL.html) on Steve Blank’s (http://steveblank NULL.com/)Customer Development Model (http://www NULL.slideshare NULL.net/sblank/customer-development-at-startup2startup),” which is a must-understand methodology for folks starting companies.  Check it out!

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The Risks of Misclassifying an Employee as a Contractor

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Client: “John, could you prepare an independent contractor agreement for me?”

John: “Sure.  Who’s it for?”

C: “Her name is Ruby N. Rails.”

J: “What’s she going to be doing?”

C: “She’ll be doing web development, reporting to our Chief Architect.”

J: “How closely will she be supervised?”

C: “Very closely.  Our Architect has very firm ideas as to what needs to be done, and needs to have her on-site pretty much every day.”

J: “How many hours per week will you use her?”

C: “This is full-time.”

J: “How long will you be using her?”

C: “Oh, indefinitely.  For the foreseeable future.”

J: “You know, Ruby really sounds a lot more like an employee than a contractor.  There are some real risks in your not hiring her as an employee.”

C: “Really?  What are they?”

J: “If things didn’t work out, and you had to let her go, she might apply for unemployment insurance, which could trigger a California EDD audit, which could trigger an IRS audit.  If they find that any of your contractors are really employees, you could be hit with back taxes, back wages, overtime pay, and penalties.  This could be a really significant amount of money.  Furthermore, if she were to be hurt on the job, she wouldn’t be covered by your worker’s compensation policy, so she could go after your company for her medical expenses.”

C: “Do you really think I’d get an IRS audit?”

J: “I can’t say.  But the Obama administration is stepping up enforcement.  Check out this New York Times article (http://www NULL.nytimes NULL.com/2010/02/18/business/18workers NULL.html?scp=1&sq=INDEPENDENT%20CONTRACTORS&st=cse).”

C: “So what should I do?”

J: “If you really want the relationship to be as you described it, I’d recommend you hire her as an employee.  Otherwise, you could hire her on a project basis, with specific deliverables, a finite timeframe, and milestone-based payments.  Or restructure the relationship in other ways that make her look more like a contractor than an employee.  Here, take a look at the IRS ‘independent contractor test’ (http://www NULL.twc NULL.state NULL.tx NULL.us/news/efte/appx_d_irs_ic_test NULL.html) and the California Employment Development Department ‘test for employment.’ (http://www NULL.taxes NULL.ca NULL.gov/icore NULL.bus NULL.shtml#California) These tests set forth criteria the IRS and the EDD use in determining whether an individual is an employee or a contractor.  And, if you do retain her as a contractor, be sure to file a form DE 542 with the EDD within 20 days of retaining her, provide her with a Form 1099 by the end of January each year, and file the 1099 with the IRS by the end of February each year.”

C: “OK.  Thanks!”

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The Legal Requirements for Using Unpaid Interns

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Last week, my business partner Ed brought his son Alex (whose school was on spring break) into our office for an afternoon of what Ed referred to as “slave labor” (i.e. assembling packages of marketing collateral).  We and Alex were both lucky that the engagement was only a half-day; Alex because he had better things do with his vacation, and Ed and me because we would have risked being in violation of California’s minimum wage laws!

If you’re considering hiring unpaid interns for your business, you’ll need to meet certain Federal and state requirements; otherwise, you’ll run afoul of the laws that require that you pay a minimum wage (which is currently $8.00 in California). Recently, the California Division of Labor Standards Enforcement (DLSE) issued an opinion letter (http://www NULL.dir NULL.ca NULL.gov/dlse/opinions/2010-04-07 NULL.pdf) stating that it follows the “six-factor trainee/intern exemption test” adopted by the U.S. Department of Labor.  The six factors are as follows:

  1. The training, even though it includes actual operation of the employer’s facilities, is similar to that which would be given in a vocational school;
  2. The training is for the benefit of the trainees or students;
  3. The trainees or students do not displace regular employees, but work under their close supervision;
  4. The employer derives no immediate advantage from the activities of trainees or students, and on occasion the employer’s operations may be actually impeded;
  5. The trainees or students are not necessarily entitled to a job at the conclusion of the training period; and
  6. The employer and trainees or students understand that the trainees or students are not entitled to wages for the time spent in training.

Bottom line, your internship program needs to have a bona fide educational purpose and educational content, and not just be a way to get free labor.  I sure hope Alex doesn’t read this post.

Thanks to Wilson Sonsini (http://www NULL.wsgr NULL.com/WSGR/Index NULL.aspx) for the good client Alert (http://www NULL.wsgr NULL.com/WSGR/Display NULL.aspx?SectionName=publications/PDFSearch/wsgralert_unpaid_internships NULL.htm) re: the DLSE opinion letter.

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The Elements of a Contract

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In my last post, I described a scenario where an entrepreneur drafted his own contract, because he was just concerned with establishing a meeting of the minds between the parties, and not with creating legal rights.  So what are the sections of a contract that an attorney would have added, and what are their functions?

You may recall that the entrepreneur drafted language describing the TRANSACTION, RESPONSIBILITIES OF THE PARTIES, COMPENSATION, and TERM AND TERMINATION.  A more comprehensive contract would also have contained some combination of the following:

1.  RECITALS (or “Whereas” clauses): These are statements that give the reader some background re: what the parties are trying to accomplish.

2.  REPRESENTATIONS AND WARRANTIES: These are factual assurances that the other party needs in order to do the deal.  Representations are statements regarding the present.  For example, a software licensee needs the licensor to represent that it has the right to license the software.  And an investor needs representations regarding a company’s capitalization before deciding to invest.  Warranties, on the other hand, speak to the future.  A company may warrant, for example, that its product will meet certain performance requirements.

3.  COVENANTS: These are promises that a party will do certain things in the future.  For example, a private company may promise to provide investors with financial statements on a periodic basis.  Or a borrower may promise to maintain certain financial ratios while a loan or line of credit is outstanding.

4.  CONDITIONS: In some deals, an obligation of a party is conditional upon something happening first.  For example, a typical acquisition agreement will have numerous “conditions to closing.”  The agreement provides for a closing at a future date, but the acquiror’s obligation to purchase may be conditional upon, for example, certain key employees signing employment agreements, the deal being approved by certain regulatory authorities, etc.

5.  CONFIDENTIALITY: These are typical NDA terms that state that neither party will disclose the other party’s confidential information or use it to the detriment of the other party.

6.  INTELLECTUAL PROPERTY: If the parties are collaborating to create IP, the agreement will need to address who owns it and what rights, if any, the other party has to it.  Or if a party needs rights to the other party’s existing IP, the agreement will need to contain a license to that IP.

7.  LIMITATION OF LIABILITY: The parties may seek to limit their liability under the contract to a specific dollar amount.  They also seek to eliminate their liability for certain categories of damages, such as “consequential damages” (i.e. damages which don’t directly flow from the breach, but are a consequence of the breach—a typical example is lost profits).  Dollar limits are often heavily negotiated, while exclusion of consequential damages is usually reasonable and not negotiated.

8.  INDEMNIFICATION:  If the contract results in one of the parties being sued by a third party, under what circumstances must the other party provide the defense and pick up the tab?  This is often a negotiated provision.

9.  WARRANTIES AND WARRANTY DISCLAIMERS:  What kinds of promises are made by the seller re: product performance?  Contracts often contain “express warranties” made by the seller, and a “disclaimer” of all “implied warranties.”  This means that the seller is giving only those warranties contained in the contract, and not the warranties that, absent a disclaimer, the law applies to most deals (e.g. implied warranties of merchantability and fitness for a particular purpose).

10.  BOILERPLATE: Contracts usually have a section at the end that has a title like “Miscellaneous” or “General.”  This is the “boilerplate,” so named because, like the steel sheets used in the early 20th Century for printing text that would be widely reproduced without changing, these provisions are thought to be pretty standard and unchanging.  There’s some truth to this, but it’s dangerous to ignore the boilerplate.  While some boilerplate provisions (such as “Entire Agreement,” “Modification,” “Counterparts,” “Waiver,” “Severability,” and “Force Majeure”) often vary little from contract to contract, others (such as “Assignment,” “Survival” and, to some degree, “Dispute Resolution”) are very deal-dependent and important.

This overview was intended to give you a “big picture” view of the elements of a contract, so that you can more effectively review contracts that land on your desk.  Future posts will deal with some of these elements in more detail.

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Drafting Your Own Contract

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“John, I need a contract for a deal that I’m doing.  It’s for such a small dollar amount, and it’s so low risk, that I can’t really justify having you draft it.  Do you have a template I can use?  What advice can you give me?”

Many of you may be in the same situation as my client.  You’re doing small, low risk deals, and you have a very limited budget for outside counsel.  How should you document these deals?

Obviously, if you will be doing numerous transactions that don’t vary much from deal to deal, it may be cost-effective to have your lawyer create a template for you.  He or she may have a good template to work from, so modifying it to create your template may be very inexpensive.

Unfortunately, my client’s deal was a non-standard, “one-off” transaction, so the template that I had would have required a lot of modification.  So we explored whether it would make sense for him to draft the contract himself.  Some of the questions we discussed were: what’s the dollar amount of the deal?  What are the possible downside scenarios and how likely are they to occur?  What’s the term of the contract?  How well do you know the other party?  Will intellectual property be created?  Will either party need an IP license from the other?

Once we determined that the dollar amount ($2000) and risk were very low, and there were no IP issues, my client made the decision to draft the contract on his own.  He really just wanted to get a “meeting of the minds” re: what each party was to do.  He was not concerned about creating legal rights or negotiating leverage in the event that the deal did not work out.  He was content to document the business terms, but not the legal terms, of the deal.

So I advised my client to describe in his contract, with as much specificity as possible, the following business terms:

1.  TRANSACTION (“Who delivers what”): What is the transaction?

2.  RESPONSIBILITIES (“Who does what”): What does each party have to do during the term of the agreement?  When is performance required?

3.  COMPENSATION (“Who gets what”): What is the compensation?  When must it be paid?

4.  TERM AND TERMINATION: When does the contract expire?  Can a party terminate for convenience?  If so, how many days’ notice must they give?  What are the consequences of terminating for convenience?

I can’t recommend that you take this approach without knowing more about your risk tolerance and the specifics of your transaction.  But I do recommend that you engage in an ongoing risk-reward (i.e. cost-benefit) dialogue with your counsel.  Corporate and transactional lawyers are, to a large degree, risk managers; part of their job is to help you make informed decisions re: when to use their services and when the more prudent course is to take some legal risk.

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