Legally Structuring Your Startup with Shawn McBride

Source: GeniusDen archive transcript checked against the recording. Administrative opening and closing material is omitted; the presentation wording is otherwise preserved with light readability edits.

All right, so let's open by talking about a partnership. We have three partners, this is a real case. We have Malone, Chu and Patel. Malone owns the company, he does all the right things. He goes out and gets everybody signed up as employment-at-will. They agree that they're just employees. They're working together on the partnership, but later, Patel comes back and says, "You agreed to make me and Chu partners, Mr. Malone," and takes him to court. And a court looks at it, and what do you think the court does with these facts? They're working together, there's an employment-at-will agreement, they're clearly employees, but you know, a few times, you know, he's said, "Yeah, I want to make you my partner in the future." What do you think a court does with this?

Audience Member: It's just verbal. They didn't have anything in writing.

Shawn McBride: Just verbal, doesn't have anything in writing, yeah.

Audience Member: So they're not partners.

Shawn McBride: Okay. Anyone else, any other guesses, what a court's going to do with this situation?

Shawn McBride: They're all working together in the business, you know, and they're always together. So it's a very small company, you've got the three of them working together, and you know. One is clearly the owner and has employment-at-will agreements, but has said, you know, yeah, I'll make you my partner sometime in the future.

Audience Member: Did he acknowledge that?

Shawn McBride: Did he acknowledge it?

Audience Member: They said, you've told us this, and he said, yeah, I told them that?

Shawn McBride: Yeah, I think he acknowledged it, yes. Yes.

Shawn McBride: Yeah.

Audience Member: The time period in which...

Shawn McBride: So, yes, essentially this: the court in this case does find that they're partners. It says your promise to make them a partner, and treating them as a partner, makes you a partner. So what is the test for a partnership?

Audience Member: It's like a common-law marriage.

Shawn McBride: Essentially, yes. There is a common-law marriage idea in the partnership world, and that is, if you have two or more owners taking on a common enterprise as co-owners for profit, then you're a partnership, right? So as long as you've got these two people taking on an enterprise, sharing the profits, the court can find there's a partnership, and that's what they did. They looked at this analysis and said, "Acts like a partnership, looks like a partnership, must be a partnership." It's the co-owning and sharing of the profits and the enterprise together.

Part of it is also holding yourself out as partners, that's another test you'll see come in as a secondary thing. You know, did you say you were partners? Although there's cases out there where people have said they're partners, and the court didn't find that they were partners. But all this goes to the fact that you need very careful documentation. You need to document who's in, who's out. You need written documentation very clear on who the ownership is. You know, we're going to talk in a minute here about your entity documents, what form of entity are you, but you want to be clear about who the owners are. You don't want to leave this ambiguity out there and have these discussions going on with people, and have the test of, you know, are we partners or not, up to the judge or the jury, which is what happened in this case.

So, looking more broadly, you know, it's very advisable to have an entity. A partnership is your default. If you have multiple people going on and doing a business together, you are a partnership. One person, sole proprietorship, two or more people, partnership, unless you do something otherwise. What are the characteristics of a sole proprietorship or a partnership? Well, it's really nothing special. It's just the way of calling the business. Sole proprietorship, it's you personally, you know, so if you form a company, that's a separate legal person. An LLC, a corporation, separate legal person.

A sole proprietorship is not a separate legal person from the owners of the business, so if you have a sole proprietorship, all of your assets are exposed, any liabilities of the business are your liabilities. There's no firewall between the person and the business. Everything is merged together. If you're a partnership, a general partnership, the form of partnership that defaults if you don't do anything special, same deal, except slightly different. So your personal assets are fully exposed for this general partnership, except you're exposed for all the liabilities on behalf of the business, which means, even if it's not you taking the action, if it's your partner taking the action, you're exposed.

You have partner A, partner B. Partner B goes out and has an accident with the car, partner A, all his assets are on the line. Full exposure, no limits. That's what happens if you don't form an entity. So step one, we always tell people, unless there's some special reason you want to be a partnership, tax planning, other considerations, you're going to want to form an entity. So the next question becomes, what form of entity? So, what do you guys think? What form of entity should you form a company as?

Audience Member: LLC?

Shawn McBride: LLC, okay. Depends, yeah. That's what I tell my clients, it depends. We get a lot of people coming in the door and they say, well, you know, so-and-so told me I should be an LLC, or somebody said I should be a corporation. A corporation's better than an LLC, an LLC is better than a corporation. It really depends on your circumstances. Where are you going with this business? You know, from the very early days, you need to get your vision together. Where am I going? What will this business be? How do I want to exit this? And that's going to start back-filling into what type of entity you pick.

Are you going to go through a private equity realm? Are you going to take it through venture capital? Are you going to go out and bring the investors in? Do you want to go public? Where do you want to be when you exit the company? What does the future of this company look like? Then we go backwards to what entity this should be. Private equity groups have loosened up a little bit. It used to be, if you wanted to get private equity around, you had to be a corporation. They would not invest in an LLC. That's changed a little bit, so now you do have the possibility of getting private equity investment with an LLC. But if you were going to go public, you're probably moving to the corporate stage sooner than later.

C-corp, yes, yes. And a corporation, for legal purposes, S-corp, C-corp, are largely the same, it's just a tax differentiation, right, whether you're...how you're taxed. But the S-corporation is challenging, because you have to meet certain IRS requirements, including all your holders have to be U.S. persons. Can't have any entities essentially. You can have single-member LLCs, but you really are limited on what you can do with an S-corporation, so S-corporation and a public company just don't fit together, because you can't control your stockholders like that.

Shawn McBride: Right, yes. Yes, there's a taxation difference between these types of entities. A C-corporation, and we're talking in generalities. You can do some tax planning and break some of these rules, but C-corporation is a separate tax entity from the owners. So you have tax at the corporate level, you know, income, net income, pay corporate tax, and if you make a dividend to your owners, personal income tax to the owners for that dividend.

Audience Member: So that's double tax.

Shawn McBride: A double tax, that's right. That's the exposure there. So if you, let's say you have 100 dollars profit in a corporation, pay your 30 percent corporate tax. You have 70 dollars of profit. You pay a dividend to your stockholders, they got to pay tax on that 70 dollars, you might have 50 dollars left at the end of this thing. Whereas an LLC, or an S-corporation, these are what they call flow-through entities. So, any profit, loss, expense characteristics, all get transferred to the personal tax returns of the owners. You have what they call schedule K-1 partnership tax return. And on that schedule K-1, you reflect all the income, losses, et cetera of the business on a proportionate basis, and then each of the stockholders will then report that on their tax return. Is that making sense? Okay.

So, LLCs, I like them. If I can get a company to be an LLC, if it makes sense in their business structure, that's good. It's simpler, you know. A corporation, you're going to have, unless you do something special, you're going to have a board of directors. You're going to have to have meetings. You're going to have an annual shareholder meeting requirement. You've got to keep records of all this. Board actions, et cetera. What do people do? They don't do it. You know, in the real world, people get behind on their corporate formalities. They forget to update the stock certificates when people change. They forget to have their board meetings. They go three or four years without an annual vote. Very messy, and then that starts creating potential exposure for the owners, which we'll talk about in a minute.

LLCs, on the other hand, very simple. You know, you can set it up to not have meetings. You don't have to have a vote every year to set your board of directors. You don't even have to have a board of directors. You can manage it however you want. Whatever makes business sense for you. So if the LLC is consistent with the future trajectory of the company, a lot of flexibility there. You can also set it up very easily to have, let's say you have an outside investor come in, and they want to have veto rights. You know, yes, you can go run the business, but I don't want you doing this, this or this without my permission. You know, you can set up GeniusDen with my money, but I don't want you to open up GeniusDen 2 unless you come talk to me. Very easy to build that into an LLC. A little more difficult than to build that into a corporation, although you can.

Audience Member: Veto rights?

Shawn McBride: Veto rights, yes. Veto rights are a common thing in an LLC agreement. When we're putting together an LLC agreement with an outside investor, there's typically a list of items that are veto items. People will sit down and say, you know, basically, you're going to let the company do all the day to day, all the normal activities will be within the purview of the company, but then as soon as you have something extraordinary, then the investor will generally want to be notified, and have to approve it. So you set that split. Corporation, LLC, then we'll see some other things sprinkled in here and there. You know, you'll see some LLPs, and LPs, and other entities.

The LP has been popular for investment entities, starting to give way to the LLCs. We're starting to see more and more of those investment entities as LLCs. So it's a changing landscape, but almost -- the large majority of entities are either LLCs or corporations, unless there's something special going on. So you're going to want to pick one of those, and you'll want to get out of that general partnership bucket, because you want to protect your assets, right? That's what a lot of this is about, is protecting your assets.

And a step beyond that now, once you have your entity, you need to run it properly. You need to do the right things with your entity, if you want to have liability protection. So you need, and the big concept out there is veil piercing. There's other ways you can be exposed, but the big one is what they call veil piercing, which is a court kind of ignores the entity, right? Because we talked about this firewall, right? And the term that's come into the cases is a veil: the corporate veil, or now an LLC veil. You have this protection between yourself and the entity, right? So the two are separate legally. But the court says, in some cases, that's unfair.

You know, it's not the right thing, if that's not a true business, and that's what a lot of this comes down to, what they call an equitable analysis. The court's going to look at fairness, and say, is it fair to treat that business separate from the owners? And what they're looking at, let's say somebody gets injured back to an auto accident. Somebody gets hurt in an auto accident, and it was the LLC or the corporation, was out there doing their business. The driver was working for the company, they were delivering their supplies, and they hit somebody. That victim now has injuries, medical bills, et cetera, and if they come looking to the LLC or corporation for money, and the LLC or corporation doesn't have enough, now the court's going to do a fairness analysis. Is it fair to say, you, victim, don't get your medical expenses paid, you don't get your pain and suffering, because that corporation's out of money? Or are we going to look to the personal assets of the owners?

When we get in these situations, the court does a veil piercing analysis. They look at fairness, and some things they're looking for there is, did you keep -- oh, yes?

Audience Member: I have a question where it's the other way around. If you did something personal to somebody and they wanted to go after you, but you didn't have enough personal assets, could they go after the business?

Shawn McBride: That's what they call reverse veil piercing, so it's the same, similar concepts, but it's reversed, and that does happen sometimes. Yes, if an owner, particularly of a small company, you know, single owner, it's not uncommon for it to be this reverse veil piercing analysis. The court's looking backwards to say, is it fair that you've kept this corporate money separate from your personal money? Both tests are about, are these being treated as separate entities, separate businesses? Are they truly distinct from each other? Is the business a business that's run on its own? Is the personal, personal all on its own, you know, are the records kept cleanly? Are the business expenses paid from the business account? Are the personal expenses paid from the personal account? Are the receipts of the business deposited in the business account? Are the personal receipts deposited in the personal account? Are all the transactions between the owners documented? There's a lot of cases out there about these kind of situations, but they're looking at that formality.

Is it fair? Is it right? Has it been run as a business? Was there adequate capital for the business when it was starting? You know, if you're going to do something risky, do you have enough money there? You know, if you're going to go out and haul explosives, that's not a business that you can open up with just buying a truck and saying there's my asset of my business. You need insurance. You need to be fully prepared for that business, and the court's going to put that into its fairness analysis. You're not going to protect owners in situations where they didn't really take a chance on the business, they didn't really invest in the business. They're looking at, is this really a business? Does it deserve to be separate from the owners? That's your veil piercing analysis.

Now, there's a handful of other things you want to be aware of, for your personal liability, which is, there are certain things where the courts or the legal system has said, we need to make sure that it is fair to the public, even beyond veil piercing, that the owner or the shareholder gets that liability protection. Some of this stuff, courts have said, you know, withholding taxes. If you're withholding money from your employees, and you're the one responsible for that, you're the owner of the business, you're the one that has to remit. You'd better give that money to the IRS or the state, because if you don't, they're coming after you personally. This is the kind of thing they said, it's very important that we get our tax money, and it's withheld, therefore, if you don't do it, we're coming after you personally. You'll see the same thing in the environmental arena.

One thing I want to talk about tonight a little bit is securities offerings, right? Because you're growing companies, you want to bring in outside investors. You want to get them to invest in the business. LLC interests, people don't think about it, but typically, they're going to be classified as securities, which means SEC and state regulation of your sale of stock. So, there are a lot of exemptions out there. You know, typically, securities law 101. Every time you sell stock, it needs to either be registered or exempt from registration. So nobody wants to register, right? That's very burdensome, unless you're going to be a public company, you don't want to register your stock. Everybody wants to get away from it, because it's a lot of paperwork. Everybody wants the exemption.

There are a lot of exemptions out there. We just got some brand-new crowdfunding rules, and there is Regulation A+, among other ways you can get exemptions, but you have to qualify for that exemption. But the point with the personal liability of the owner is, you're going to be out talking to people about that stock, and telling them what your company's about, what your profits are going to be, how your company's going to operate. You'll be making all these kind of statements, and if you make statements that are not true, or you bend the truth, or you go a little too far, that person that's talking about the company and touting the stock, now it's their liability, because they made that misstatement. You need to be very careful about what you're saying, particularly in a securities-offering standpoint, as you're growing that company, okay? So, that's kind of the basics of entities and personal liability, so that's step one. That's your very, very base level foundation to allow your company to grow.

The next step's going to be bringing in growth capital, and again, we're going to look to the future. You know, what is this company going to look like in the future, how do we want to exit? How are the owners getting out, and how are they getting their money? Is it a big payday? Is it, you know, a long-term buy and hold, sell to the employees when you're 60 years old? How are you getting out, and what does that mean we're doing today? And now, we're going to start thinking about accessing capital, and how do we get money into the company? So next thing you need to do is figure out what your company's worth.

Market's changing a little bit. The days of pre-revenue funding was very hot ten years ago, and then we had the real estate bust, and all the other turmoil, and then nobody would do a pre-revenue company. Now, we're starting to see a little bit of pre-revenue funding. Companies that have a concept, an idea, plan, something innovative, can actually go out and get some money from investors, but most of the time, you need to show an income statement. You need to show you've got assets, you're making money, you're doing something. Then, investors are going to interface with you. So you've got to get to that level first.

What does all that lead to? That leads to valuation. You've got to have a value on this company. What is this company worth? How much are you going to pay for it? If a buyer's going to come in and buy the entire company, what's it worth? This is very subjective, right? Everybody can disagree on what the value of a company is. Valuation professionals will disagree, but the basics is, you're going to value what the future earnings of that company are worth to an investor. How much are you going to pay today for whatever that company's going to make over its lifetime, in one shape or form or another? So, that's your basic valuation. So you've got to figure out what the value of your business is before you start working with the investors. Once you know what the value of your business is, then you can start talking about what percentage are you going to sell, and what's that worth. It's all negotiation at this point.

This is -- this is one of the points in the life of a company where everything's fully negotiable, because you need to go to that investor. You've got to make your case for a high valuation. They're probably not going to like your valuation. They're going to think a little bit less, and then you start thinking about your cap table. What percentage ownership does everybody have? How much is that investor going to get, and what does that future of the company look like? Are you selling ten percent of your company, because you're going to sell another ten percent two years from now, to bring in the next round of money? Are you selling maybe fifteen, twenty percent of your company, because you want to stock up on money now, and grow quickly, and then hopefully use your revenues from your business to keep you growing? You need to understand where you're at.

You're also probably going to start thinking about, you know, paying your employees with stock, because you're probably going to be cash poor at this point in the business life. You've got to keep your employees motivated, so you may want to do some kind of stock plan. That's one of the questions the investors are going to be asking you in this investor process is, you know, how much is allocated to me, how much is allocated to your employees, and how much is left over for those founders? It's got to be a fair allocation, right? They want the founders to be motivated to keep growing the business, but the investor, of course, wants as much of the company as they can get, and they realize your employees are probably going to want some percentage of it too, over time. So you're probably going to set aside some stock for your employees. So you're building this cap table, you know, you're doing spreadsheets and looking at how you're dividing that ownership pie.

One thing you want to think about too is, any of that new investment dollars, you're making a bigger pie. So, a hundred percent of a small pie, but if you bring in investment dollars, you made a bigger pie. You've got more stuffing, or more material there. So now, you can make a bigger pie, and so that investor's going to want to look at that. So you've got to look at how much pie's left over for you. A hundred percent of a small pizza may be less pizza than eighty-five percent of a bigger pizza. You've got to look at what percentage you're keeping, and what value that has attached to it, right? So valuation. So your valuation of those investment dollars coming in means there's more assets there, which means, theoretically, your valuation should be higher. Remember that when you're bringing in the investment dollars. But you're building these tables of kind of where you're going.

You've got to look at your future rounds too, because the investors are going to be negotiating whatever rights, they're going to ask about vetoes, they're going to want a board seat, probably, and they may ask for what they call dilution protection, which is, in the event that you would issue stock round two or round three, they want to make sure that they don't become a smaller investor. They want to keep that same proportionate share of the company. Particularly if you're issuing shares for less dollars per share than what they bought in, so that's all negotiated as part of this deal. You're building kind of a foundation and future of the company with these investors, and interfacing. You're looking forward to where you're going with the company, so once, you know, the investment dollars will hopefully allow you to grow, grow the business.

Then, you need to start thinking about where you're going with this, and now your exit starts getting a little closer. You've got the company growing, and some entrepreneurs only want to be in for a couple of years, and we see companies successfully, two, three, four years, build proof of concept, find a buyer, sell, they're out. Other ones take ten, fifteen, twenty years before they really get to where they can do an exit. Exits happen in a variety of ways, as we know. So what are some ways you think of founders exiting from a business? What kind of stuff have you seen in your experience?

Audience Member: Pass it on to their family?

Shawn McBride: Pass it on to the family, yeah. Very, very common.

Audience Member: Selling to a competitor?

Shawn McBride: A competitor, yeah.

Audience Member: IPO?

Shawn McBride: IPO, yeah. All right, so those are, I mean, you're looking for a buyer in one shape or form, right? So family transfer, that was, for private business, that was the norm up until fifteen, twenty years ago. That was standard, you know? Parents build the business, they pass it to their kids. Kids run the business, they pass it to their kids. We're seeing a real shift in that now. I mean, a generational thing has happened, particularly with the health condition of the parents living longer and being healthier longer, they stay in the business longer. A lot of times, the children reach adulthood, they start working at some other business, and then that child might be 35, 40 years old, before mom and dad are ready to transition the business. We're finding a lot of times, the kids don't want the business. But that's still a viable option, if you have the right situation. That's one way you might exit. So you might be looking forward to that.

Another one that's very common is a competitor or a strategic buyer, right? You might find somebody who's your supplier, that wants to buy you to integrate, or a customer. Some kind of strategic acquisition of some sort. Or a competitor buying you out. So that is another form of exit, and a lot of people will start building their plan knowing which competitors or which companies they want as their buyer. A lot of investors are very happy to see that. They say, how are you getting out of this? A lot of companies will have already built a list of, these are our sale points, these are people who we're going to target as potential buyers of our company. So, that is one way to plan your exit.

The gold standard has been the IPO, right? Get out, get your big payday. If you build a company right, and you can do a full fledged IPO and bring the money in, that can be an awesome payday. That can be great for the owners. Long path, you know? Going public is not inexpensive. It's a risky transaction, there's a lot of pieces that go into doing an IPO. You've got to get the company to a certain size. You've got to have, obviously, a solid income stream, a good balance sheet, a good income statement. But then, you're going to be bringing investment bankers, you're going to go on generally what they call a road show. You're going to be out, interfacing with all these investors, and showing them what your company is, and talking to them about your projections, and what your business is, and getting to that level.

Then, there's a timing issue with an IPO. You know, there's been many an IPO company that has prepared to do an IPO, and then the market goes down right before they get the IPO closed, and that's always a risk that's ever-present in an IPO. But when it happens, when all the stars align, you have the right company, the right balance sheet, get the investors excited, bring the money in, it can be a great payday for the owners, and typically, as part of the IPO, the founders will take money off the table. The investors will actually buy some shares from the founders, so they get that liquidity day.

I was at a conference about a month ago, and one of the speakers had exited via IPO, and he was talking about how he took his son to McDonald's, and he had to call the credit card company before he went to McDonald's, to make sure he had enough money to buy lunch for his son, and then his son wanted to get a bigger meal, and he said, no, you can't have that. Two weeks later, he sold his company for 180 million dollars. Because he was cash poor. Owned a company, didn't have any money to go to McDonald's, because his credit card balance was at its max. This is not an uncommon story for founders. They get all their money tied up there. And the investors love it. This is what the investors want. They want you hungry, and they want you cash poor. This is... You've seen this, right?

Audience Member: Yeah, I mean, it's just brutal.

Shawn McBride: Yeah.

Audience Member: I've lived it.

Shawn McBride: You've lived it. They want to see that hungry, and that will actually be part of the investors' analysis, is, are we aligned with the owners? Are the owners going to be working hard? I've seen investors want to haircut the owners' salary, so typically, you have the ownership group, and they're drawing some salary off the company, and they say, well, the most you're going to get is 45,000 dollars a year. I mean, they're keeping those salaries nice and low, so that there's not a lot of cash coming out of the company, because they want that founder to be very incentivized, to maximize the value of the company, and they don't want that money coming out, because every dollar coming out of the company is hurting valuation for that exit. Because when you're looking at an exit situation, it's about your net income.

Usually, it's a multiple, I mean, that's the typical way, the simplest way to value a company is taking your net income times some multiplier, depending on your industry, and the nature of your company, et cetera, and that gives you a valuation. So the investors know, the lower the salary of the founders, the higher the income, the bigger the number after you apply the multiplier. So every dollar they can shave off the control party's salary is the more money they're going to have at the end. This is the real analysis.

We talked a little bit about the IPO exit process. You know, you're building a huge document. It's going to be your registration statement, that's going to be shown to the investors. You're going to describe the business, all the warts, all the problems you've had, all your risk points. These documents end up being about 100 pages. You're really throwing it all out on the table, and you're laying out to your investor what your problems are, what your risks are, what all the situations are. Yet, the investor still will buy some of these companies, but you have to, you're basically airing all your dirty laundry at the time of an IPO, and you've still got to get the money in there. So it's a tricky analysis.

What does an exit look like via sale? That's another one where you need to kind of do some planning, because IPO, you're going to have this public disclosure document, which is going to describe the business. Or a private sale, a merger, you're going to have a due diligence process. Somebody's going to sit down and look through your company, and they're going through your underwear drawer as well. They want to know where everything is. I've had companies in due diligence, you know, these questionnaires that you get in the due diligence process will be ten to fifteen pages long.

So you get ten to fifteen pages of questions, just preparing for a sale of the company. What states are you operating in? What products are you selling? Have you paid all your sales tax? You know, what's your ownership structure? Do you have any stock options outstanding? And they just go on and on and on, for pages. They want to know everything. Have you promised anybody stock? What have you told your employees? Let me see all your contracts with your employees. Let me see all your vendor contracts. Let me see all your customer contracts. Let me see all your software contracts. Everything in your company is coming out at this point. Let me see your corporate documents. You need to be ready for this process.

Audience Member: That's when you get started.

Shawn McBride: Yeah. Right.

Shawn McBride: Definitely should be keeping a log of it, right. Definitely. You should start. Dropbox is --

Shawn McBride: Right, because you want to have this stuff ready. That's why we're talking about now, because today, in your startup role, if you know you're going to exit this way, you want to build this virtual, nowadays, virtual file cabinet. You want to have that stuff sitting there, ready, because when it comes, the questions are coming. Now, your waste pickup is not going to be an important contract. But your contract with your people in these offices? They're going to want to see that, because they're going to say, what are the risk points here? You know, is the liability protected? What if somebody has a right to renew indefinitely forever? These are things that become an issue. Employment contracts. What have you promised your employee? Did you promise somebody some equity, because that's a problem. Typically, the buyer wants 100 percent of the company.

One of my clients in my career, we had a very interesting situation. They were being acquired by a sizable national acquirer. Actually, very interesting, the acquirer was such a frequent buyer of other businesses, that they had their own lawyers full-time. Usually, you hire outside lawyers when you're buying somebody else, but this buyer was such a frequent buyer that they had lawyers to do the buying process that were on staff. So they sent their due diligence questions, and among them was, give me your employment agreement, show me a stock option agreement.

The stock option agreements of my client were unfortunately not properly drafted, and they contained a provision saying that, and typically, what you'll have in a stock option agreement is a provision that says, in the event that we're acquired, you can basically get rid of people's stock options. You can force them out, so you know, people had the stock option, you work a certain amount of time, and then you'll get stock in the company, but there's a provision there saying, if we get acquired by somebody else, all bets are off.

Well, they didn't put this provision in there saying if we get acquired by somebody else, all bets are off. So the acquirer starts looking at it, and says, well, now, I can't acquire 100 percent of you, I only get 97 percent of you. I'm not real interested in this, because what is that 3 percent? That 3 percent becomes a minority stockholder, which is a pain in the butt for a new owner, right? A new owner doesn't want, they want to take the entire company, they want to do what they want to do with it. They don't want to be answering to somebody that's got 3 percent that's saying, hey, you're not doing the right thing for me, you're not treating me fair. You're being mean to me, whatever.

So this company says, I'm not that interested in 97 percent of the company. My client now has a situation where they've got these stock options outstanding. 3 percent of the company, potentially, and their acquisition's about to come to an end. So we go back to these stock option agreements. There's no way to terminate them, under the way they're written, unless the person stops being an employee. So the company actually went to the employees and said, either you can give us your stock options voluntarily, or we're firing you. Which, as you can imagine, that was not popular for employee relations. But that's what they had to do, to get their acquisition done, and the CEO, was like, we're not losing this acquisition because, you know, of course, the CEO's a majority or a large stockholder, he wants his payday. And that's what they got forced to do. It was a bad situation, but there is something buried in that document that they didn't think of.

I had a colleague of mine, an attorney I was working with at another law firm, representing a buyer in an acquisition, and the company that they were acquiring had software as one of its key assets. It was a company that was licensing software. They start digging through piles and piles and piles of software licensing agreements, reading them, and there's people that, you know, you'll hire attorneys that will just read all these things. Buried in one of them agreements was, they gave somebody a license which allowed that person to re-license that software. All their value destroyed, right? Yeah, the acquirer said no, never mind. Now, you've got one customer out there that can allow anybody to use this software, so I've now got a built-in competitor forever. Deal off. Not acquired, you know?

So they lost their acquisition, because of something buried in their documents. But from a practical standpoint, you want to start building this stuff, and you want to think about what this stuff looks like, in an acquisition situation. Have you agreed to such a deal with one of your customers, that it's going to be -- That the acquirer's going to have a problem with it, you know? Did you give a customer a sweetheart deal, where they're always going to have a low price forever, and that's going to potentially become a big problem in the future? Do you have a vendor that essentially controls you? Do you have an agreement with a vendor where you have to buy everything from them, and that vendor has a lot of leverage to re-price? They're going to be looking at these points in an acquisition. They're going to be going through everything, to make sure that that company looks okay for an acquisition, so be prepared for that due diligence process. Know it's coming.

You can spook a buyer. If you don't give the due diligence documents to the buyer in a timely manner, they're going to say, well, what's wrong with this company? Why doesn't this company have these records? What's going on over there, you know? You don't want them to think you're a Mickey Mouse operation. You want them to know that you're serious, and that you're running your business as a business, and that you've prepared yourself for the acquisition process. So just anticipate that in a sale situation. You know, you also want to, more on the financial side, as you're preparing for an acquisition, you'll start doing what they call window dressing. You'll start getting your financials ready. You'll want to typically, the acquirer's going to look at the last three years of earnings and expenses. So you may start clumping some expenses and moving them around. A lot of times, that multiple is the last year of earnings times five, six, seven, whatever's appropriate for the industry. So if you can get some expenses front-loaded, get them done now, 18 months before your acquisition, and then be very lean that last year before your acquisition, you can get a higher multiple and a higher value. So you can start prepping yourself.

The sooner you start prepping yourself, and preparing for that acquisition, knowing when it might happen, the better. But you also need to be available for that unexpected offer. You want to have these things in your Dropbox, or wherever, your filing cabinets, if you're doing physical files, or somewhere. You want to have all this stuff ready and organized, in case that unexpected offer comes. You just never know.

Those guys over at WhatsApp, have you heard about that acquisition? Billions of dollars, there's like 50 employees. I mean, it was like the highest dollar per employee... Huh? They got bought by Facebook, yeah. I mean, the valuation was insane. I wish I had the numbers with me, but it was one of these deals where nobody expected that to happen, but Facebook wanted that technology and wanted that customer base, and they went after it. So you just don't know. Something could come out of left field. You could be in the right position at the right time. Somebody could want your software, because it bolts onto their software, or something like that. So you need to be prepared, in case that comes quickly, and you're going to be out of your business sooner than you thought. You don't want to scare that buyer off, by not having any records in the right condition.

So, that's kind of prepping you for an exit. Family exit, you know, that becomes a little tricky when you have siblings, and I know you guys are siblings in a family business, and it's tricky when you have siblings that don't agree, or sometimes, you'll find a situation where one sibling wants to be in the business, and the others don't. Then you've got to figure out how to allocate that money fairly, right? Because that ownership of that business is valuable, you know, essentially it comes with a job tied to it, and we'll find a lot of times where we have situations where you have 2, 3, 4 siblings, and 2 or 3 of them want to be in the business and one or two of them don't, and then you've got to figure out how to make this fair among them, and how it looks fair, and how it's run fair.

So you want to do some planning there, and you've got to think about that. Are the siblings buying in, is this just a gift, and the other siblings are going to get some other asset in exchange for not getting ownership of the business? What works for the family, what works in their specific circumstances? You've got to look at that kind of planning. The family situations are often a little more tricky than others.

Audience Member: What happens if something happens to the owners—if they die?

Shawn McBride: That's right. In another one of my presentations, I talk about the 4 D's in planning a business partnership, right? The 4 things if I have a business partnership coming in to me is death, disability, divorce, disagreement. I'm planning for these 4 D's, right? Death, that ownership of that company is an asset, not unlike your pickup truck, and so in the event somebody dies, that pickup truck's going to somebody, right? Typically a spouse or the children, or some combination thereof, or it goes to the will, and goes to whoever the person who died said gets it, right?

Through probate or a will, that ownership of that company is going somewhere. And so now, whoever gets that ownership of that company, in the probate or the will, they essentially step in the shoes of the owner. So unless you've done some special planning, you now have a new owner of the company, a new partner. A new shareholder, and they get to step in there and do whatever they want to do with that stock. You know, they can vote for new directors in a corporate situation. If it's an LLC, they now go to the meetings. They now get the books and records, they can ask all the questions. They're an owner of the company, so you want to plan for that scenario. We often will use insurance, or other buyouts, to make sure that we don't get unexpected owners. We'll do some advanced planning for that, but you've got to be cognizant of that. You want to run through those what-if scenarios. Where's that going, in the event somebody dies?

Audience Member: Can you repeat those 4 D's?

Shawn McBride: Yeah. Death, disability, divorce, disagreement. And I'll hit divorce too, because that one isn't as apparent, but if somebody gets divorced, particularly here in Texas, a community property state, that ownership interest's usually getting divided among the two ex-spouses. So you're in business with Joe, he gets a divorce from Sally. Now, you have two partners, Joe and Sally are both partners and owners of your business, which can completely change the partnership dynamics. We've had cases where, you know, we had four partners, and then suddenly, we had five partners, and the whole dynamic's different. And those two ex-spouses will usually disagree about how you should be running your business, so they'll be asking a lot of questions, and it's going to be hard to keep both of them happy.

Audience Member: Can that be built into the document, that person, and if they're --

Shawn McBride: Divorced, yes. Yes. Essentially we will typically do that with an LLC. As soon as we see marriage in the ownership, we'll typically build provisions in there, for dealing with what happens in a divorce. Typically, what you're going to have is an agreement to pay cash to the spouse that's leaving the marriage, rather than give them ownership of the company, because that keeps your ownership very clean. What we'll typically have is, if I represent a business partner, I will go to the other partner and say, your spouse better sign this, or else I'm not going into business with you. You don't want that unknown factor.

Audience Member: What if that partner comes back from Vegas and says, I got married?

Shawn McBride: Well, it depends on how careful you are. That is a scenario that we will talk to some of our clients about, that not everybody addresses. But what you want to do is build a provision in your agreement that says, Bob, if you're going to get married, you've got to get your future wife to sign this agreement, and agree that she's not going to be an owner of this company before you get married. And if you do get married, Bob, without telling us, then you broke this agreement, and we're taking a hit against your ownership interests. So you can build that into the agreement.

Audience Member: You can say this is worth one dollar, so if you go and get married, then you can lose it?

Shawn McBride: You lose. Right, you're gone, Bob. You can be as Draconian, I mean, as long as you build it properly, you can be pretty Draconian.

Shawn McBride: But you want to keep that unexpected owner off the table, because you don't know what's going to happen. You know, I had a client that had an ex-wife, who got a part ownership of a real estate holding entity. And then she wasn't happy, because they were reinvesting the money to pay the mortgage down, and she was getting a K-1 tax statement, we talked a little about that earlier. So she was getting paper income every year, but she wasn't getting any cash. So she's writing a check to the IRS every year. Well, she started rattling, and started sending a bunch of questions in --

Shawn McBride: No, she was just the wife, she was a wife of an owner, and then they got divorced, and she became a part owner. She became, it was five owners, she got divorced, she became a ten percent owner of the company just by virtue of divorcing one of the owners. Yeah.

Audience Member: And she had to start paying them.

Shawn McBride: Then she was getting the K-1 tax statements, and that went on for a year or two, and then she said, "I'm getting tired of paying money to the IRS, I'm going to go bug that partnership and ask them a bunch of questions about how they're running their business, and whether it's fair to me." Then, she got a lawyer, and the lawyer started asking a bunch of questions, and she started questioning the partners, and why they were paying the mortgage down, and not distributing cash. How do you think the conversation's going between the partners at this point? I mean, they're spending a lot of time meeting with their lawyers, and talking about defending their actions as a partnership. Not pretty.

Audience Member: So a pre-nup doesn't cover any of that?

Shawn McBride: Depends on how well you do your pre-nup. I mean, it depends on how broad the pre-nup is. I mean, I typically, if I'm representing the company or one of the partners, I want it into the partnership documents. I don't want it outside the partnership documents, because I want to control it. I want to make sure it fits the business the way the whole company agreement works together.

Shawn McBride: Yeah. (laughter) It works for both, it works for everybody. Yeah, I mean, it's a... You know, the interesting thing is, the conversation we find is different than just a normal pre-nup, because it's one thing when husband and wife are going to get married, and one of them says, I want a pre-nup. You know, people do it, but it kind of, it muddies the water a little bit. But when somebody comes in and says, my business partner requires that we sign what is essentially a pre-nup, then it's a different, yeah, it's easier to take that to your spouse than just, I want you to agree you're not going to take ownership. My business partner doesn't want you to ever own this business, that changes the conversation a little. You had a question?

Audience Member: The owners still have to pay taxes on those?

Shawn McBride: Yeah, if it's a flow-through entity, which this was. This was a partnership, yeah. Right, this was an LLC, taxed as a partnership. Right. Yes.

Audience Member: So all the earnings that were reinvested, that individual still has to pay taxes on that.

Shawn McBride: Right. This is not an uncommon situation in growing businesses. You'll get to a certain point, you may have tax losses in the early years, and you grow your business to a certain point, and you start showing a profit, right? Your revenue minus your expenses is a positive number, which means you're getting a distribution that, for tax purposes, on paper, you're showing a profit. So yes, you have to pay tax on that profit. But you may still be in such a growth cycle that you're putting that money back into the business. You're buying more equipment, you're expanding your facilities, you're doing all this kind of stuff. So yes, you could very much be in a situation where --

Audience Member: That profit, and you're buying more buildings, or more assets and stuff, those would be considered, like, expenses, so...

Shawn McBride: No. You've got to look at the accounting definition of expenses, and the tax definition. Okay, so, they always say businesses essentially have three sets of books, and this is not anything crooked, but you typically have, you know, your financial statement books, right, and this is done under one set of accounting. Then you have your tax statement books, that's done under a different set of accounting. Then you kind of have the economic reality of the business. These are three separate sets of financial statements. Under both financial accounting and tax accounting, if you go out and buy that, I buy that pickup truck, because I need to deliver supplies, that's an asset. It's not necessarily an expense. Then I start depreciating it, I have to divide the expense of that truck over its useful life, right?

I paid 55,000 dollars for a pickup truck. I divide that over five years or whatever the IRS says the life of a pickup truck is. So 11,000, 11,000, 11,000, 11,000. So I paid 55,000 dollars for a truck, but in this current year, I only have an 11,000 dollar expense, and a 44,000 dollar asset that goes forward. This is how this happens, right? You go buy a building, in particular, right? A building is a long-term asset, depreciated over like twenty-five, thirty years. So I buy this building, and now I've got twenty-seven years of depreciation deductions. But I just paid out, I paid the full purchase price, year one. So on paper, I mean, cash is out. The money's gone. But the depreciation doesn't come for many years. So if I took last year's profit, bought the building this year, you know, I still... Yeah, I'm showing a paper profit.

Audience Member: Meanwhile, you also passed the CPA exam.

Shawn McBride: Yeah. I did that for a while.

Audience Member: He also juggles, I'm not sure.

Shawn McBride: I haven't gotten to that one yet, you know, I want to. I want to. There was a guy in my Goldman Sachs class. He had an online internet business. But yeah, he was a magician, too. He'd get up in front of class, he'd toss stuff around. I was like, damn! Why can't I do that? So I'm going to take some questions here in a minute, but before I do, you know, here on this checklist, there's some things for you, as far as how to protect your investment. This is kind of talking about more of the day to day. We've talked about laying a foundation, talking about your exit, what an exit looks like. These are some things kind of along the way that you probably want to think about. You know, what are your agreements with your employees? What rights do you have? How are you protecting yourself there? Intellectual property, usually very important in a startup situation. Yes?

Audience Member: My point is this: in writing my agreement for software development for an app, there were chunks of code that belonged to someone else and needed to be licensed, either under Creative Commons or another license. That made it a complicated document. The coder was basically trying to license his work to me with certain restrictions, versus, "I'm paying you for your time, and I'll do whatever I want with it." That was a big issue for us and eventually contributed substantially to the relationship falling apart, because he couldn't get his head around this idea. He could take the code, redesign it, and do something else with it.

Shawn McBride: Oh, yeah. Well, you need to know what the ownership is, and this goes to your valuation exit, right? I mean, that's -- Right, I mean, that's key. You know, when somebody builds, you know, a wonderful -- When somebody builds Uber, right? They build Uber, and Uber wants to sell to somebody else. Well, the first thing the acquirer wants to know is, can I still run Uber when I buy this company? I've still got that revenue stream coming in. They don't want something saying, well, Uber can use it, but if you sell this to somebody else, you can't use this software anymore. Well, that Uber's worthless. It's not available to a buyer, so that's often baked into agreements, particularly with software. Change of control, and that's going to be key, especially if you're using somebody else's software. You've got to look at what happens in the event of change of control.

That's kind of a trap for the unwary too, like, you get some companies that get to a certain size, and they've gone out and bought Microsoft Office, and Adobe and all these kind of fun things for all their computers, and then they get acquired by somebody else, and if they didn't negotiate the right change of control provisions, that new buyer has to come in and re-buy all the software for all the computers. I mean, this happens. But it can also, yeah. Yeah. But then this will happen. Even more importantly than that, I mean, that's a pain in the neck and a lot of wasted money, and may hurt your valuation, but more importantly, then, your intellectual property.

If you're building a software application, you need to be able to sell that software application as it is to your buyer. You don't want to tell them, oh, well, you can't have this same software. You know, you in the coffee business, if you have a contract with a customer, you want to make sure that that transfers if somebody buys your business. They don't want to say, oh, well, I got to go out and renegotiate with all your customers, and all your customers are now free to go buy their coffee from somebody else. They want to buy that customer base and that revenue stream. They want to make sure it continues through.

Shawn McBride: Yeah.

Audience Member: You'd recommend the LLC, but if you're going to be in, let's say, you're in venture capital. You want to incorporate.

Shawn McBride: Right.

Audience Member: What's that process? I've heard you roll it up.

Shawn McBride: Okay, so you're talking about capital raising in a corporate situation?

Audience Member: I'm saying, you know, if you want to be an LLC for the simplicity.

Shawn McBride: Yes.

Audience Member: You don't want to start out as a corporation.

Shawn McBride: Yeah.

Audience Member: But then you want to take on outside investors.

Shawn McBride: Right.

Audience Member: I mean, what is that process?

Shawn McBride: Oh, okay, yeah, I mean, that is typically what they call a conversion. A couple of different ways you can do it.

Audience Member: Changing from what?

Shawn McBride: LLC to a corporation.

Audience Member: So now, I'm going to be an S-corp.

Shawn McBride: Right. Yeah, that's typically what they call a conversion. There are other ways you can do it. It's not that hard. You typically, you have your existing LLC, you build your documents for your new corporation, and then you file what they call a certificate of conversion with the state, and you say I'm converting this to this. A hundred bucks. The hard part --

Audience Member: And you tell the IRS?

Shawn McBride: Keep the same EIN. The hard part though, is your ownership structure, how do you transfer that over? So it really depends on how complex you've made your ownership. If you're a one owner company and you go from LLC to corporation, basically, non-event. If you've got classes of stock, and you've got, you know, five owners here, and then you've got preferred stock with these people, and you brought in a series of A round, and they're all in your LLC, and now you're going to a corporation? You know, that's going to be a lot more complex. You've got to re-seat everybody on the other side, and make sure you do it properly. That becomes challenging. So it really depends on where you are in your life cycle.

Shawn McBride: Yeah, yeah, okay. So --

Audience Member: So I guess the question would be, S-corp or LLC?

Shawn McBride: Yeah, okay, yeah.

Shawn McBride: Okay, well, I'll go through it. I can handle all three. So S-corp, LLC, C-corp. Okay, the way I like to talk about this is go back to the history of corporations and LLCs. So corporations, so originally, you didn't have corporations, right? And then, at some point, we started having them by legislation. You could only be a corporation if Congress authorized you to be a corporation. So we had some railroads that were corporations in the 1800s, and so that was the early days. And then, at some point, they kind of democratized this. They said, well, people should have access to this, because we want companies to build, we want capital formation. So the states, New Jersey, and then a bunch of other states started allowing people to form these corporations. But you had to be a corporation. And they had a very particularized way to do it.

If you look at a corporation and the way our government's set up, there are actually a lot of parallels, right? So we've got citizens, corporations have shareholders. Citizens or the shareholders' vote for either congresspeople or board of directors. Board of directors kind of run the business on behalf of their shareholders, and then they get other people to do stuff. Either employees, officers, or federal agencies or whatever. It's very similar to the way our government was structured, is the way they structured a corporation. But it's very formulaic. Certificate of incorporation, unless you do something special. You have a board of directors, you have bylaws that tell the directors what they do, you act in a very particularized, very structured way. People started getting very comfortable with this, in limited liability, but people said, damn, this structure is just very burdensome. You know, I have to always do it this way. It doesn't fit my smaller company. I want more flexibility, more freedom, and that's where the LLC came around. So this --

Audience Member: It came around about 20 years ago?

Shawn McBride: Yeah, somewhere in that range, the 70s. Yeah, so they said, okay, well, you know, let's come up with something new that lets people kind of set up and form capital and bring in investors, but we don't need all this formality. We don't need to require everybody to have a board of directors. We don't have to have all these annual meeting votes. We don't have to require all of that. Let's let them do it the way they want to do it, which is where the LLC comes in. Freedom of contract. You can basically set that LLC contract up however you want. So for a --

Shawn McBride: A lot of people think a corporation's safer because it's been around longer, but the courts have really come down and said, it's the same analysis. Veil piercing, is it fair and equitable to veil pierce? And yes, you're right. A lot more easy to get yourself in trouble with the formalities on the corporate side, generally, because a corporation has these kinds of coded requirements. Must have a board of directors. Must have an annual shareholders' vote. Must do this, must do that. LLC, if you write your LLC documents right, you don't have all these requirements. You make it very simple and very streamlined. As simple as authorizing a transaction, right?

So, if I'm representing a corporation and it's set up the normal way, and I want to go out and buy a piece of real estate, I've got to have a board meeting, I have to have board resolutions, the board has to authorize the officers to do it, then the officers have to go sign it. Paperwork, paperwork, paperwork. I can put a special provision in my LLC agreement that says, you know, Joe Blow can buy any piece of real estate he wants, as long as he says he's buying it on behalf of the LLC, we're good to go. And then Joe Blow could just go out and say, I bought a piece of real estate. Done! And here went a stack of paper that was that high, five documents, and now it's just Joe Blow, sign the paper, because I had one paragraph in my LLC agreement.

Audience Member: Are there any additional liabilities with an LLC?

Shawn McBride: Not really. I mean, you need to obviously do it correctly, but you know, the same analysis. You're taking off that formalities thing with the LLC versus the corporation. Yeah. I mean, but you still have to run it like a business, you still have that whole analysis. You still have to look for those holes. I don't know if you, yeah, you came in a little bit later, you know, we were talking about, you know, like remitting your payroll taxes, environmental liabilities, securities law, these are all holes where even though you have an entity, you can have personal liabilities, so you got to make sure you're still plugging those gaps, whether you're a corporation or an LLC.

But you know, I like the flexibility of an LLC, particularly when I start getting multiple owners, because it's much easier for me to blend the pie together and make it work for everybody with an LLC, so you've got that freedom of contract. I can make it work the way everybody wants to work, and put it in harmony much easier. I can do a lot of the same stuff with a corporation, it's just going to take a lot more paperwork to build it into that structure, because I've already got a free... They basically already framed the house for me, so if I want to make the rooms different, I've got to go tear out part of this and put it in different rooms, and move walls around, whereas an LLC, I just build the house the way I want.

Audience Member: For the corporation, for an S-corp, do you still have to have a board of directors meetings?

Shawn McBride: Yes. Yes. Thank you for bringing it back to that, because I did not address the S-corp versus C-corp. Yes. An S-corporation and a C-corporation are identical for state law purposes. They are the same thing. They're a corporation, and you have to form under a particular state. Texas, Delaware, that's a whole other analysis, which state you form in. But you're a corporation for state laws. The only difference between the C-corp and the S-corp is you file an election with the IRS. I elect to be taxed as an S-corporation, or I'm going to be a C-corporation. The difference is, the C-corporation, got that double taxation, taxed at the C-corp level, taxed at the shareholder level, if there's any dividends. S-corporation, flow through tax, much like a partnership. Not exactly, but much like a partnership, you're dividing those profits among the owners and distributing it out to the owners.

Audience Member: The requirements are all the same?

Shawn McBride: As far as board meetings and stuff like that. Now, there are special requirements for an S-corporation. You know, there's an IRS checklist. No more than 100 shareholders. All have to be US taxpayers. Basically, residents or green card holders. Can't be held by an entity. So you can't have a corporation investing, you can't have a corporation as a shareholder of an S-corporation. So you have these kinds of restrictions, on how you structure the ownership of an S-corporation, which you have to be very careful about. Yeah, I mean, you're basically running down this IRS checklist to make sure you get it done right, you know?

And one of the tricky things with an S-corporation, I had a client that wanted to bring in outside investors into their S-corporation. The first problem is, one of the investors was a three owner LLC, so that didn't fly, so we had to restructure that. Then, we had to build a lot of stuff in there to make sure that one of these -- So you couldn't take more than one owner LLCs, because you can have a one owner of an LLC of an S-corporation, but what happens if that person dies, and that becomes two owners? Now you've blown your S-corporation elections. So you have to do a lot of planning and a lot of protection in an S-corporation situation, to make sure you don't blow your S-corporation election.

Audience Member: So, you've got some series LLCs.

Shawn McBride: Yes.

Shawn McBride: Yes, so let's talk about series LLCs, and I have an entire... Let's talk about what a series LLC is first, and then we'll go from there. And this is something, we get this question a lot. I've developed an entire presentation on that as well, so it's a bit of a lengthy topic, but I'll cut it down, so we can talk about it. So, a series LLC, the concept is essentially, you have one LLC, a master LLC, and then you have each series of it, series are basically separate slivers.

Audience Member: Are they separate entities, or not?

Shawn McBride: Depends on the state. Some states say they're separate entities, some states don't make it clear what they are. So you always have the one LLC as an entity, but it's not clear what each series is. Some states... It's a mess. IRS has different analysis, depending on which state your series LLC is formed in. Texas, do you remember, sir?

Audience Member: It's not a separate entity.

Shawn McBride: It's not a separately... Yeah, and I'm not sure how that, so I think taxation-wise, that puts you back into being, it consolidates for taxes. It's ugly. The taxes of a series LLC get very expensive. That is one downside of a series LLC.

Audience Member: I'm an attorney, a paralegal.

Shawn McBride: That's right, yes. And we have an immigration attorney, yeah. Very attorney-heavy room. So you have these separate series, right? And the idea is that each series has its own assets and liabilities, and there's kind of a firewall, so the idea is supposed to be that you only look to the assets of that series. So it looks really good on paper. The big issue with series LLCs, the biggest issue, there's a number of them, but the biggest one is bankruptcy. Because the whole reason you're building this is in case somebody sues me, right? If somebody sues series 1, I don't want them getting the assets of series 2 or series 3. That's most likely going to be tested in a bankruptcy scenario, right? Because series 1 is going to... Series 1 owns a house, and somebody gets hurt at that property, and they sue series 1, and you say, oh, well, my only asset's the house. I don't have no money, you know? I'm bankrupt, right? And you're going to end up in a bankruptcy process.

The problem is, if you look at the federal bankruptcy code, it talks about who can file for bankruptcy. And the federal bankruptcy code was written and not updated with respect to series LLCs, so it doesn't talk about a series LLC as a filer. So there's a question mark in the world, can a series LLC file for bankruptcy? And a lot of people say no, which means, series 1 has this problem. Series 2, series 3 are positive, right? They have net assets, the assets are greater than liabilities, but the bankruptcy court might just say, well, your filer's the LLC, so everything's into the bankruptcy process. We just don't know. And the series LLCs aren't being used, because a lot of the bigger, larger, sophisticated investors won't touch them. They're just like, put them as separate LLCs.

Audience Member: So if property 1 was separate from property 2, and property 1 has a lawsuit, but property 2 LLC has the assets, is property 2 protected in a bankruptcy?

Shawn McBride: Maybe, maybe. Now we're talking about what's a completely different analysis. It's not piercing the veil here, now it becomes consolidation, which is also a bankruptcy concept. And there's also a state law overlay to a similar concept under state law, but what they have is consolidation. So, a bankruptcy court, when they look at a bankruptcy, they have equitable power, which means a lot of power. They can do what's fair and right, back to, very similar to the veil piercing analysis we talked about. So the bankruptcy court comes in, and they look at the pieces, and they say, what is this business?

A famous case under state corporate law, but makes the point, is, you know, back in about the 60s, a lot of New York taxicab companies said, oh, great. You know what we'll do? We'll make every cab, every cab will be a separate corporation. This cab is owned by ABC cab company, Inc. This is owned by ABC cab company 2, ABC cab company 3. And then somebody got hurt by a cab, and the cab company says, well, guess what? You can sue that corporation, take my taxicab!

Now, the medallion on the taxicab is pretty valuable, but you know, the right to operate a taxicab in New York City, that has its own value, but they said, basically, that's all you get. You get my taxicab, and my right to operate a taxicab, and I'm bankrupt. And the court said, no, that's not fair. This is one consolidated business, this is being run as one business. It's not right that you would be able to just give away one taxicab. You're running all these taxicabs as a business. So, courts are going to do this kind of analysis if you get too fancy. You need to have each --

Audience Member: What about Uber and Lyft?

Shawn McBride: Yes. Uber and Lyft, a whole different issue, but they haven't really separated the entities. The issue with Uber and Lyft right now, and we wrote about this on our firm blog a couple months ago, is, these people driving these taxicabs, they try to set them up as independent contractors. And, yeah, she's laughing. And that's the way the business is structured, right? So, you know, you drive, and they say, you're not my employee. But then, Uber says your car has to be clean, and we're going to look at your car, and it has to be a certain model year, you know? You have to go where we tell you to go, you're going to drive the person wherever they tell you to go. Are they controlling them?

A California court has come out and said, yes, there is control. You're telling that person what to do, you know? Lyft, apparently, they're supposed to meet you with a fist bump. I mean, all this stuff's written up. They're telling the people how to conduct their business. A true independent contractor is somebody that you don't control. I hire somebody to come put a new roof on my house, I don't tell them how to put the roof on my house, I don't tell them when to put the roof on my house. I might agree on the dates or something, but I don't tell them what hours to work, I don't tell them what safety equipment to wear. They come put a roof on my house. That's an independent contractor, you know?

An employee, I say, you come sit over there, type on the computer, enter these things, do these ten tasks today, be here 9 to 5. Uber's kind of looking a little bit like an employer, right? You know, you're telling them what to do, how to do it, where to go, you know, all that kind of stuff. So California court has said, yeah, these Uber drivers are employees. So that's the...

Audience Member: A lot of back taxes.

Shawn McBride: A lot of back taxes. And states love back taxes. States love to reclassify independent contractors to employees, because then they take penalties and back taxes, and they make a fortune, yeah.

Shawn McBride: Oh, yeah. Yeah, I mean that's part of it too, is of course there's a lot -- People are getting injured by Uber. But Uber does have, like, a master policy.

Shawn McBride: Yeah, well, I mean, Uber theoretically, they're employees, right? So now, okay, let's just talk a second about employees, because it's very tangential, that, so. So these drivers have been classified, at least by California --

Shawn McBride: And feel free to chime in, and tell me if I get it wrong, but, so you have --

Shawn McBride: Right, that's why I, yeah, that's why I wanted to zoom out on this. So you have employees, California court has said Uber people are employees, right? So now, these are employees. Well, what does that mean? You know, you the employer are typically responsible for your employee's actions on behalf of the business. So, you know, Joe's out driving our pickup truck, I don't know who owns that truck, but I keep pointing at it. Joe's out driving his Dodge Ram, and Joe hits somebody. Exactly. And Joe hits somebody with the Dodge Ram, right? And so now somebody's hurt. Well, he was doing that on behalf of the business, and now the employer has to answer for that. The employer's liable in business, right? The business that sent him out to do its bidding in that truck is now liable too. So you're liable for your employee's acts on behalf of the business.

But then there's also kind of this negligent hiring theory that's out there. If you hire just somebody horrible, you know, that's come up in hotel cases and stuff like that, you just, you don't run a background check, you're not careful about what you hire. You hire somebody bad, and then they punched somebody in the face. Now, even though that's outside the employment, punching somebody in the face, normally an employer's not going to be responsible for that, but in this case, that employee that you didn't do a background check on, you weren't careful about, punched somebody in the face. Now you potentially have liability for that. So I think the Uber analysis would probably come down very similar to that. You know, if they were indeed an employer, and California says they are, I don't think, Texas hasn't gone that far yet. But if that Uber person was indeed an employee, were they careful, were they responsible in hiring them, and you know, are they responsible for that act?

Shawn McBride: Yeah, and the Texas Workforce Commission, or whatever the applicable state authority, will open up a whole file on that. As soon as they hear that, somebody says I was an employee, I was really an employee, and they got me classified as an independent contractor, you're going to get a bunch of questions in the mail, and you're going to be answering about what the relationship was like with that person, and what you did and didn't do.

Audience Member: What about when the state classifies as a franchise?

Shawn McBride: Classify what, the person?

Audience Member: The independent contractor.

Shawn McBride: Yeah. Okay, well, you know, franchises are a whole other area of the law. So we talked a little bit about corporations and IPOs, and a franchise looks a lot like an IPO really. I mean, it's... If you've met the test of a franchise, you've got franchise disclosure, which looks like a registration statement and talks about it, but the idea is the franchise is just, the franchise is just lending its name and its system and operations to the franchisee. It's not... So that is, but the franchisee is running the business. The courts kind of recognize that difference. That doesn't necessarily become an employer-employee relationship, because they're separate businesses, but there's limits on what the franchise can do. They have a brand, they have a mark, a trade name, they have a way of operating. You know, a recipe for the food, whatever. That is transferred down, but they again can't control the hiring, firing, can't control the day-to-day, can't control that. So as long as that's not happening, then you know, they're not...

Audience Member: I was thinking of making the person a franchisee instead of an independent contractor.

Shawn McBride: To make the person a franchise. Instead of being an independent contractor. The key is the test, and there's two sets of tests here in Texas. The IRS has a, I think it's a 24 point test, and I may get these numbers backwards, I don't do employment every day. One of them has a 24 point test, one of them has a 20 point test. You basically look through this analysis on independent contractors. Are you passing or failing this 20 point test? Do you tell them when to show up to work? Do you tell them what to wear? Do you supply their equipment to them? You know, these kinds of things. Do you tell them how to do the business? Are they free to do it the way they want? Can they hire people to do the work for you? You deal with a checklist.

Shawn McBride: Yeah, exactly. Yeah, I mean, you know, it's one thing for me to hire Courtney and say, Courtney, I want you to, you know, come to my office and do A B and C, versus saying, Courtney, get this done, and then Courtney's free to hire another employee to do it, right? You don't care how Courtney gets it done, you just wanted the task done. They're different. This is your 24 point test, or 20 point test, or whichever one applies. Because the IRS test and the Texas test are slightly different, so you've got to comply with both, you know, because you don't want the IRS re-classifying you and Texas not.

Audience Member: The Department of Labor has its own?

Shawn McBride: Yeah, the Department of Labor has its own analysis. So they're all, you know, each regulator does their own thing. But yeah, if you could be a true franchise, and you meet that test, then you're probably also going to meet the independent contractor test. It's about the degree of control, how much you're telling them what to do, and whether you're just kind of letting them use your system of operations, or whether you're actually controlling how they're doing it and what's being done.

Audience Member: What about establishing a nonprofit? Is that outside of LLC? Or if you wanted to, like, I like the idea of the series thing, in terms of like I have one company, like the brand of the company to do one thing, but then another to do just the work of the nonprofit function.

Shawn McBride: Yes. Okay, so you're typically going to want a completely separate entity for a nonprofit. I have not seen anybody set up a series for profit and a series for nonprofit. I just don't think you're going to make that. Yeah. So nonprofit nowadays can be in a variety of different legal entities. You don't have to be a corporation or an LLC. You don't have to pick one. It used to be, you always had to be a nonprofit corporation. Now you can be a nonprofit LLC. You've got this freedom. But from a state law perspective, they look a lot alike, whether you're a for profit or a nonprofit.

You know, you're still going to have your board of directors, you're still going to have your officers and all that's going to look alike. You're going to run it the same way. But the difference is, the nonprofit then is going to be qualified for tax purposes to have that nonprofit status, to be able to not have to pay net income tax, to be able to possibly have charitable donations, et cetera. So that's a different layer of analysis. So basically, you're layering a structure on top, and you do a nonprofit application with the IRS. You say, this is what we're doing, this is who our beneficiaries are. They ask you a bunch of questions to make sure you're not passing money off to your officers indirectly, that it's not for their personal benefit, this is actually for a public good in a protected area, and then you get your nonprofit status.

So, very similar in how you run it and structure it. Of course, you don't have owners of a nonprofit. You just have beneficiaries, and people that are getting benefits from it, but very similar in the governance, but different in what you can do with the business and how you can operate it. Okay. Well, thank you.