Legal lifecycles of businesses: securing ownership of the business assets, part three

September 13, 2010

This is the third of 18 articles tracing the legal lifecycle of a business from its formation, through its operation and to its sale. As a Texas attorney located in Lakeway, Texas (outside of Austin in Central Texas), John Drisdale is limiting these articles to a summary of Texas and federal legal matters. As these articles evolve, their numbering and order may be adjusted or supplemented by his blogs as appropriate.

Article Three–Securing ownership of the business assets

A newly formed corporation, limited liability company or other entity will have minimal assets – typically the cash or property initially contributed by the owners for their ownership interests.The company will need cash, tangible assets and intellectual property to conduct business, and these business assets may be contributed to or purchased, created, borrowed and leased by the company.

Reverse alchemy – turning gold into lead. Unlike the alchemists of yesteryear unsuccessfully attempting to turn base metals into gold, modern businesses have little difficulty in turning valuable assets into “base metals.” In the urgency to begin business, it is too easy to postpone ownership “details” as something to address later. Seldom do the owners realize that postponing these details may destroy the value of the business and create personal liability for the owners.

Obtain IP assignments. The “show stopper” question in purchasing a technology company is “who owns the technology?” Sellers can be shocked to learn that consultants who were paid to write software own it instead of the company. Besides being disappointed to learn that they have nothing to sell, being exposed to tremendous liability for copyright infringement adds insult to injury. While the company may be able to assert an implied copyright license to use the software, this “after the fact” defensive posture is no substitute for an agreement properly transferring ownership to the company. Knowledgeable purchaserswill significantly reduce the purchase price or even terminate discussions if ownership is unclear because the seller may be selling potential infringement liability instead of the desired technology.

Many sellers mistakenly believe that the company owns the software as a “work made for hire” – an exception to the general rule under federal copyright law that the creator/author owns the copyright. Software created by an “employee” within the “scope of employment” is a “work made for hire.” However, “employee” and “scope of employment” are problematic terms based on unpredictable, factual determinations under state law.If not an employee for state law purposes, the consultant will own the software that he or she created. Even if the “consultant” is an employee for state law purposes, the company may not own the software as a “work made for hire.” Consider the situation of a computer science graduate who accepts employment by the company as a receptionist– not a rare occurrence in difficult job markets. One day when the phones are slow the receptionist, in a bid to qualify for a higher paying job,writes the essential software code to solve an issue being discussed in the office. Although an employee, he or she was hired to answer phones rather than write software. Since the software was not created within the scope of employment, the receptionist owns the software. Due to these issues and other complexities, knowledgeable businesses require consultants and employees to sign intellectual property assignments to the company, even if the intellectual property is likely to be a “work made for hire.” For more information on this complex concept, see Circular 9 [Works Made for Hire Under the 1976 Copyright Act] published by the U.S. Copyright Office at http://www.copyright.gov/circs/circ09.pdf.

Trademarks.The Secretary of State’s determination of name availability for a corporation or limited liability company merely indicates that the filing may be made with the Secretary of State. This determination is not the same as a trademark search. If the company uses a name trademarked by another, it may later be required to cease all use of the name necessitating a withdrawaland revision of all advertising, directory listings, stationery, signage and any other use of the trademarked name. Similarly, the name or packaging of a product or service may infringe a trademark or service mark and the business décor may infringe the trade dress of another business. While a trademark attorney should review the legal issues to determine if a proposed mark would violate a registered or pending mark, some of the more obvious infringement situations may be identified by self-conducted searches of available domain names, the U.S. Patent and Trademark Office database at www.uspto.gov, and of the desired name or phrase using internet searches engines.

No Commingling. In addition to infringement liability of the company for using intellectual property it does not own, failing to document title to business assets may create personal liability for the owners. Corporations, limited liability companies and certain other entities are generally considered to exist separately from their owners and to be solely responsible for their own liabilities and obligations. However, there are exceptions to this general rule such as the “alter ego” doctrine. When owners disregard the separate existence of an entity and treat the company as their alter ego, courts will frequently allow third party claimants to sue the owners. If the company uses assets of the owners to conduct business or if the company uses business assets to benefit its owners (such as directly paying home mortgages or other personal expenses), this commingling of assets may lead to a commingling of liabilities. Proper documentation and procedures can prevent the company’s owners from becoming personally liable to a person injured by an employee.

Transfer procedures. While business assets may be acquired through loans, purchases, leases, owner contributions or the creative efforts of employees and, with proper documentation, consultants, the optimal approach should be determined after consulting tax and legal advisers.For IRS as well as liability purposes,the transfer should be documented by an appropriate entity resolution and an assignment,bill of sale, loan agreement, promissory note or lease. It is especially important to document all transactions between the company and any of its owners.

Consent to transfer. Occasionally third party consents are necessary to transfer assets to the company. Consent requirements most commonly arise for transfers of leased equipment, assets or office space and for assets purchased with loans. Any individual or entity with a line of credit or other credit facility should examine the credit documents for consent or notice requirements before transferring assets. Transferring assets without the required consent may constitute a default under the credit or lease agreement. While a default permits the lender or lessor to accelerate the maturity of all obligations under the loan or lease, frequently the creditor or lessor will use the default as an opportunity to increase the interest rates or rentals to a “market” rate.

Transferring obligations.When assets are transferred from owners to the company, the company should assume the corresponding obligations. Just as there are procedures for transferring assets, in assuming obligations the company should:

- after consulting with a tax advisor, properly document the assumption of the business loans obtained by the owners prior to formation of the company

- obtain new loans directly as the borrower, even though the owners may be required to endorse or personally guarantee the loan

- approve the assumption by an appropriate resolution of the corporation’s board of directors or the limited liability company’s managers

- amend all leases, contracts and other arrangements for equipment, leased premises or furniture to reflect the company rather than the owner as the contracting party

Planning to fail?The ubiquitous quote that “failing to plan is planning to fail” is applicable to securing ownership of the business assets. Understandably owners are eager to pursue the business, sometimes at the expense of “those legal details.” However, ignoring legal details may undermine the entire foundation of the business and leave the owners without any reward after years of work or, even worse, with personal liability

John Drisdale practices business and corporate law in the Austin, Texas area and is a principal in the law firm of Drisdale Law Firm.

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John Drisdale

Drisdale Law Firm

John Drisdale is a principal in the Austin area business law firm of Drisdale Law Firm. Drisdale believes in Ben Franklin’s theory that preventive legal costs are typically a fraction of remedial legal costs such as litigation and dispute resolution. John graduated second in his 1979 law class at Baylor University and was Editor in Chief of the Baylor Law Review. He is a published author and speaker on several important legal topics that affect small business including business entity formation, buy-sell agreements, purchasing and selling businesses, contracts, and commercial real estate. His professional experience includes practicing business law as a partner in an international law firm and serving as general counsel for a publicly traded global corporation. John now focuses on the "entry to exit" preventive business law needs of small to mid-size businesses. Drisdale limits his law practice to the areas he knows best and helps his clients manage the rest. Litigation, tax and other specialty matters are referred to other attorneys and professionals. John’s practice is based in Lakeway Texas where he has been an active Board member of the Lake Travis Chamber of Commerce for many years. He enjoys making business owner educational presentations to area groups and is a lifetime learner.
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