Saturday, July 15, 2017

Texas Secretary of State’s Form of Certificate of Formation

Mother, should I trust the government?” – Pink Floyd

That question answers itself, does it not?

I’m pretty sure Pink Floyd did not have form documents promulgated by the Texas Secretary of State’s office in mind when those lyrics were written. Nonetheless, it’s a helpful reminder that you often get what you pay for when it comes to free legal forms. Or perhaps the economic maxim of TANSTAAFL (“There ain't no such thing as a free lunch”) would be a more suitable reference.
Regardless, for those looking to incorporate a Texas for-profit corporation, I do not recommend using the Texas Secretary of State’s form of Certificate of Formation (Form 201), which is available on the Secretary of State’s website here.   

What’s so bad about Form 201?  Well, nothing is horrible about it – you could certainly file it (and pay the related filing fee) and have yourself a functioning Texas for-profit corporation. But an experienced Texas corporate lawyer is likely to suggest a using a form of Certificate of Formation that includes other helpful provisions in addition to the minimum required provisions dictated by the Texas Business Organizations Code (TBOC).

For example, Form 201 does not include any of the following provisions which are common for Texas for-profit corporations:

Director Exculpation.  As a rule, directors do not like to be subject to potential personal liability in connection with their service as a director of a corporation. So Texas corporations often elect to take advantage of Section 7.001 of the TBOC, which permits a Texas corporation to exculpate (relieve from liability) its directors from liability to the corporation or its shareholders. They may achieve director exculpation by adopting a director exculpation provision as part of the corporation’s Certificate of Formation. The basic Form 201 does not include a director exculpation provision, though one could elect to supplement the basic Form 201 by adding such a provision (or any of the other provisions discussed below). Our clients typically elect to include a director exculpation provision in their Certificate of Formation when forming a new Texas corporation.

Mandatory Indemnification of Directors and Advancement of Expenses. Likewise, directors typically think it’s a good idea to have corporations on which they serve indemnify (cover the costs of) directors from potential liability arising from their service as a director. While exculpation relieves directors of liability to the corporation and its shareholders, indemnification protects directors from claims made by third parties. Section 8.101(a) of the TBOC permits Texas corporations to indemnify its directors who gets sued by a third party because of their service as a director so long as the director (1) acted in good faith, (2) reasonably believed that his or her actions taken in an official capacity were in the corporation’s best interest, (3) reasonably believed that his or her actions in all other cases were not opposed to the corporation’s best interests, and (4) in the case of criminal proceedings, did not have reasonable cause to believe his or her conduct was unlawful.

Section 8.103(c) of the TBOC permits a Texas corporation to adopt a provision as part of its Certificate of Formation which makes permissive indemnification mandatory.  That means that once it has been determined that a director has met the 4-part standard described in the previous paragraph for a corporation to be permitted to indemnify a director, then the corporation would be required to provide such indemnification for the benefit of the director.

Of course, sometimes it is unclear at the outset of a suit against a director whether or not the director has met the standard for permissive indemnification. Meanwhile, the director may be incurring substantial expenses in defending himself or herself against third party claims. In cases where it has not yet been determined if the director has met the standard for permissive indemnification, Section 8.104(a) of the TBOC permits Texas corporations to advance expenses to directors in connection with their defense of a claim, so long as the director provides a written statement confirming that (1) the director believes he or she has met the standard for permissive indemnification, and (2) the director will repay any expenses advanced if it is ultimately determined that he or she has failed to meet the standard for permissive indemnification.    

Section 8.104(b) of the TBOC permits corporation to adopt a provision in part as part of its Certificate of Formation requiring the corporation to advance expenses to directors who have provided the written confirmation described in the previous paragraph. As one might expect, directors of Texas corporations typically think it is a good idea to include such an advancement of expenses provision in the corporation’s Certificate of Formation.

Action by Written Consent of less than all Shareholders.   Let’s say you want to amend the corporation’s Certificate of Formation to change the name of the corporation. As with any other amendment to the Certificate of Formation, that change requires the approval of the corporation’s shareholders. If all shareholders are willing and able to sign a written consent approving the name change, then shareholder approval is fairly simple. But let’s further assume that all shareholders fully support the name change, but one of the shareholders, holding only 1% of the corporation’s outstanding shares of stock, is on vacation and is unable to sign a written consent approving the name change. What then? Well, if the name change is important and the corporation does not have a provision in its Certificate of Formation authorizing shareholder action by less than unanimous consent, the only way the corporation may change its name is to call a meeting of the shareholders to approve the name change. Such a meeting must be done in compliance with applicable notice, quorum, proxy, and other provisions of the corporation’s bylaws and relevant provisions of the TBOC. Finding a time and place convenient for an adequate number of shareholders to attend in person or by proxy may be difficult.  On the other hand, a corporation with a Certificate of Formation that includes a provision permitting shareholder action by less than unanimous written consent of its shareholders (as permitted by Section 6.202 of the TBOC) can very easily circulate a written consent to its shareholders requesting approval of the name change.  Once signed by a sufficient number of shareholders, the name change may proceed. 

Section 6.204 of the TBOC provides that a corporation need not provide advance notice to shareholders of shareholder action taken by written consent, so depending upon the advance notice of a shareholder meeting required in the corporation’s bylaws, the right of shareholders to take action by written consent can be important when timing is critical for a matter requiring shareholder approval.

Of course, that’s just of few of the possible Certificate of Formation provisions ignored by the Secretary of State’s Form 201. A Texas corporation might elect to include all sorts of other provisions in its Certificate of Formation, including provisions authorizing preferred stock, providing for preemptive rights, providing for cumulative voting rights, electing status as a “close corporation,” or adopting other provisions which may be appropriate for some Texas corporations.

Bottom line, careful consideration should be given to the options available to a new corporation before just grabbing Form 201 and filing away.

Friday, June 30, 2017

360 West Magazine Top Attorney 2017

I'd like to thank 360 West Magazine for including me in their list of "Top Attorneys 2017"(their annual list of our region's best attorneys)!  This year, I was named in the practice areas of Business Law and Civil Law and Transactional.  

The complete list is available here.  

Monday, April 3, 2017

Regulation Crowdfunding Inflation Adjustments

Limits on the amount of capital that companies can raise through equity crowdfunding just grew a tad.

On March 31, 2017, the Securities and Exchange Commission (SEC) adopted amendments to Regulation Crowdfunding which adjust dollar thresholds and limits to account for inflation.

Specifically, companies that raise capital through equity crowdfunding are now permitted to raise up to $1,070,000 per 12-month period (up from $1 million).

The inflation adjustments also impacted other dollar limits and threshold throughout Regulation Crowdfunding.  For example:

  • The threshold for assessing a crowdfunding investor's annual income or net worth to determine investment limits applicable to such investor increased from $100,000 to $107,000;
  • For a crowdfunding investor whose income or net worth is below the new $107,000 threshold, the maximum amount of securities that can be sold to such investor in a crowdfunding offering has increased from $2,000 to $2,200 [or, if greater, 5% of the lessor of (i) the investor's annual income or (ii) the investor's net worth]; and 
  • The maximum amount that any investor can invest in all crowdfunding offerings in any 12-month period has increased from $100,000 to $107,000.

The SEC was required under the JOBS Act of 2012 to adjust the limits and thresholds under Regulation Crowdfunding to account for the impact of inflation.  Further adjustments are required at least every five years.

Tuesday, March 14, 2017

Cracking the SAFE: Financing Option for Start-ups

What the heck is a SAFE start-up investment and is it right for you?

SAFE stands for Simple Agreement for Future Equity.  The investment approach and the acronym itself were developed and coined by Y Combinator, a Silicon Valley-based start-up accelerator and seed investor. SAFEs have been getting quite a bit of buzz in the start-up community.

A SAFE is a convertible equity instrument used by start-up companies. The investor invests cash today in exchange for the company’s promise to issue equity in the future. What type of equity and upon what terms?  Exactly.  SAFE’s are convertible into the next round of equity issued by the company (typically a Series A preferred stock financing round) - whatever that financing round ends up looking like. SAFEs typically convert at a price discount to the Series A round and/or with a valuation cap applicable to the Series A round so that the early stage SAFE investor gets some benefit from taking on more risk by investing in the company at an earlier stage.

Here’s how it works.  Say you have a start-up company that has a great idea but urgently needs funding (sound familiar?).  You have some friends and family or angel investors that have bought into the concept and your vision, but because the company is early-stage, pre-revenue, there are no obviously appropriate valuation metrics.  The company needs equity financing sooner rather than later, but how do you price the equity at such an early stage? Whatever valuation you pick is likely to be unfair to the founders or the investors. And what other equity terms will apply (common or preferred equity, liquidation preference, dividend rate, registration rights, tag-along rights, board membership rights, voting rights, etc.)? As you can see, when you start funding a start-up, a lot of questions arise quickly.  Does it really make sense to spend a start-up’s limited time and money negotiating valuation and other deal terms at such an early stage? The parties could spend thousands of dollars and countless hours putting deal terms in place for a concept that never gets off the ground.

The SAFE investment instrument allows you to kick these sorts of issues down the road to a more appropriate stage of the start-up’s life cycle. When the start-up engages in a true Series A financing round, perhaps the financing round led by more sophisticated professional investors, such as a venture capital firm. Often the Series A investor is better able to take on the task of valuing the company and structuring the terms of the Series A investment. And perhaps the company has a revenue stream to value or at least a clearer path to defining and measuring a potential revenue stream at that point. When things go as planned, the SAFE investors can piggy-back off the added time, information and expertise of the Series A investors to hopefully achieve more equitable deal terms. The SAFE converts into the same (or substantially similar) security purchased by the Series A investors at the same time the Series A round closes.

If SAFEs sound familiar, it’s because SAFEs are in many ways similar to convertible notes, which have long been a tool used by early-stage start-up investors. SAFEs, like convertible notes, involve a cash investment today with an expectation of conversion in an equity security in the future.
Advocates for SAFE, such as Y Combinator, argue that SAFEs are superior to convertible notes because, among other things (1) SAFEs accrue no interest, (2) SAFEs have no maturity dates, and thus, no potential solvency issues for the start-ups, (3) SAFEs have fewer terms to negotiate, and thus are less expensive to implement (a SAFE is typically only about 5 pages long), and (4) SAFEs are more reflective of economic reality – investors in convertible notes rarely really intended to be a lender to the company (the convertible note is just a placeholder until conversion, typically when the Series A terms are known).

There is much positive to be said for SAFEs as a quick-and-dirty mechanism to bridge a start-up to a more formal round of equity financing. From the company’s perspective, there is much to love about SAFEs.

From the investor’s perspective, on the other hand, SAFE is a misnomer. The instrument isn’t “safe,” or at least not as safe as a convertible note or a priced equity financing round. If the start-up never issues it’s “next” round of equity, the SAFE exists in investment purgatory as neither an equity investment nor a loan. SAFEs typically provide that SAFE investors get a liquidation preference or get converted into equity upon a sale or liquidation of the company – but that could be many years down the road – or never!  Of course, no start-up equity investment is truly safe. If the company fails spectacularly, a convertible note holder is likely to be every bit as “wiped-out” as a SAFE holder. Still, there are advantages to an investor having the status and rights of a lender or a true equity holder.

That said, a SAFE investor could reasonably conclude that the cost savings to the investor (and to the company) of investing in a SAFE might outweigh the added investor protections of negotiating to acquire convertible notes or a full-blown common or preferred equity investment.     

While the SAFE investment vehicle is not for everyone, it is certainly a worthy addition to a start-up’s financing tool-box.

SAFE form documents proposed by Y Combinator are available on their website here.

Friday, March 10, 2017

J.R. Ewing -Types Continue to Vex Courts and Corporate Law

Since the dawn of our legal system, courts have had to deal with the problem of the sneaky contracting party (think: J.R. Ewing from tv's "Dallas" - or to cite a more recent example, Rumpelstiltskin from tv's "Once Upon a Time").  You know the type - someone who tricks another party into signing a contract - only after signing the contract does the other party learn further information which, had it been disclosed at the time, the other party never would have agreed to the deal terms in the contract.

On the one hand, courts like to uphold contracts freely entered into by parties which are otherwise legally enforceable.

On the other hand, courts hate to permit contracting parties to get away with fraud or otherwise sneaky behavior.

I've blogged about this issue before here when the Texas Supreme Court tackled the case of the stinky restaurant. In that case, the court came out on the side of the duped tenant whose landlord failed to disclose that the space they were renting smelled like sewer gas.

Two recent corporate law cases decided in Delaware Chancery Court highlight this ongoing tension.

In Prairie Capital III, L.P. v. Double E Holding Corp., the court considered a case in which a company was sold based in large part upon falsified monthly sales information created by the seller. Unfortunately for the buyer, the stock purchase agreement included two key provisions: (1) one in which the buyer confirmed that it was relying exclusively on its own due diligence and the seller's representations and warranties in the agreement itself, and (2) a standard integration provision in which the parties agreed that the stock purchase agreement was the entire agreement of the parties (i.e., there were no oral agreements, side deals, etc.). Fortunately for the buyer, the seller also breached some expressed representations and warranties in the agreement itself, so the buyer's case was able to proceed against the seller on other legal theories.  Nonetheless, the court concluded that so-called extra-contractual misrepresentations by the seller could not be the basis of a fraud claim by the buyer. In the court's view, the buyer had adequately disclaimed reliance on any such extra-contractual statements, even though the buyer did not use any particular "magic words" to do so.

In FdG Logistics LLC, v. A&R Logistics Holdings, Inc. the court considered a case with almost identical facts as the Prairie Capital case but reached the opposite result - the buyer was permitted to pursue fraud claims against the seller. In that case, the seller was alleged to have made extra-contractual misrepresentations (i.e., misrepresentations other than those explicitly set forth in the representations and warranties section of the purchase agreement) in documents provided to the buyer during the due diligence period before the merger agreement was signed. Even though the merger agreement in question included a statement from the seller that it was not making any representations or warranties other than those explicitly set forth in the agreement itself and there was a standard integration (entire agreement) provision, the court ruled that there was not a clear disclaimer of reliance by the buyer in the merger agreement. Without such a clear disclaimer of reliance by the buyer, the buyer's fraud claims could proceed. The court admitted that it was splitting hairs, noting that statement by the seller that it is exclusively making certain representations and a statement by the buyer that it is exclusively relying on such representations seem "like two sides of the same coin." Nonetheless, because courts hate to permit parties to get away with fraud, it will only find an adequate disclaimer of reliance by a victim when such disclaimer is crystal clear.

It is easy to see the tension at work in these types of case. Courts want to allow sophisticated and well represented parties to set the terms of their own deals - and tailor the scope of the relevant representations and warranties upon which the parties relied. That sort of flexibility keeps parties from endlessly claiming to have relied upon all sorts of statements made outside of the contract itself. On the other hand, courts don't like the idea of rewarding those who commit fraud for their dishonesty and underhanded tactics, such as failing to disclose material facts that fall outside the scope of the representations and warranties in the agreement itself but are nonetheless important to the other party.    

The takeaways here are fairly obvious:

  • If you are a buyer and you relied upon a particular piece of information received from the seller in making a decision to enter into a transaction, you'll want to have the agreement say so explicitly in the seller's representations and warranties in the agreement itself. Then, you won't have to worry about whether or not the court will tolerate extra-contractual misrepresentation or fraud by the other party in your particular case.
  • If you are a seller, and wish to minimize your exposure for alleged extra-contractual misrepresentations, you'll want to include an explicit disclaimer from the buyer of reliance on any other statements from the seller other than those in the agreement itself. And after FdG Logistics, we now know that such disclaimer should be written such that it reads as a statement from the buyer's perspective disclaiming reliance, not just a statement from the seller that it is not making any other representations or warranties.  And even though courts often claim they aren't looking for any particular "magic words," sellers should seek to include the magic words "disclaim reliance" on other statements of the seller or seller's representatives. PUTTING THE DISCLAIMER OF RELIANCE IN BOLD AND ALL CAPS IS ALSO A GOOD IDEA. 
But regardless of how carefully contracts are drafted by the parties, society will always have parties seeking to game the system by complying with the letter but not the spirit of agreements, and courts will have to decide whether to let them get away with those games or not.

Friday, February 17, 2017

Texas Bar Today - Top 10 Blog Post

My last blog post, "The Divisive Merger: A Powerful Tool in Texas," was named one of the Top 10 legal blog posts of last week by Texas Bar Today.  What do I win, you might ask?  This cool seal:

Wednesday, February 15, 2017

The Divisive Merger: A Powerful Tool in Texas

What the heck is a divisive merger?

A divisive merger is a merger involving splitting up one company up into two or more new companies.

It's a potentially powerful tool available to Texas companies under the Texas Business Organizations Code (TBOC).  And it's a tool that is not available in most other states, including Delaware.

The concept of the divisive merger is baked into the definition of the word "Merger" in Section 1.002(55)(A) of the TBOC, which defines "Merger" to include, among other transactions, "the division of a domestic entity [such as a Texas LLC or Texas corporation] into two or more new domestic entities or other organizations or into a surviving domestic entity and one or more new domestic or foreign entities or non-code organizations."

So why is a divisive merger so powerful?

Let's say you and another person own Texas Widgets, Inc., a Texas corporation that does business in two Texas cities - Dallas and Fort Worth.  Now say you wish to split the business in half, with one shareholder taking the Fort Worth operations (which will continue in business as Cowtown Widgets, Inc.) and the other partner taking the Dallas operations (which will continue in business as Big D Widgets, Inc.).  You'll just assign half of the company's assets to one shareholder or the other, right? But wait - what if one or more of the company's leases, permits, licenses, contracts or other instruments setting forth the company's legal rights include non-assignment provisions that prohibit the company from conveying rights from Texas Widgets to Cowtown Widgets or Big D Widgets?  Is the split-off transaction doomed without getting the consent of the company's landlord(s) or other parties?  Maybe not.  Depending upon the exact language prohibiting assignment in the contract or other document, the company may be able to enter into a divisive merger to split up the company's assets without triggering the anti-assignment provisions which would otherwise require the company to obtain another party's consent. If a company merges, technically no assignment has taken place - legally, it is as if the surviving company always owed the asset or other legal rights.

Even if your company is not a Texas entity, you might be able to convert or merge your company into a Texas entity, then take advantage of the divisive merger statute to complete a transaction with similar hurdles to overcome.

And there may be other situations where a divisive merger makes sense - perhaps where taking the time, effort, and expense of conveying individual assets might be unduly costly (such as conveying dozens of working interests in oil and gas properties in numerous counties throughout Texas). A merger might be able to immediately vest title to assets to a newly merged company as a short-cut to individually conveying a series of individual assets.    

Although the divisive merger can be a valuable tool, it can also be a sword used against you by savvy operators.  So when drafting anti-assignment provisions in business contracts, you might consider if the other party might be able to use a divisive merger as an end-run to a anti-assignment provision that permits mergers but not assignments by the other party.