UNCERTAINTY REIGNS

The Trump presidency brings with it a lot of uncertainty for a number of reasons.  Among them, President Trump has his own unique ideas and intends to create his own agenda apart from that of any political party.

BUT TRUMP HAS A TAX PLAN

The Trump Tax Plan.  One part of Trump’s agenda that is pretty clear is his proposed tax reforms, which are aligned with traditional conservative Republican thinking:  cut taxes and shrink government.  It is therefore likely to receive significant support.  On the Trump campaign’s website, the Trump Tax Plan is set forth in very simple terms and is summarized below.

Income Tax.  Trump wants to simplify the U.S. tax structure by, among other things, imposing only three tax brackets on individuals (12%, 25% and 33%) and only one on businesses (15%).  Currently, there are seven individual tax brackets (10%, 15%, 25%, 28%, 33%, 35% and 39.6%) and eight corporate tax brackets ranging from 15% to 39%.

Application of “Corporate” Tax to Pass-Through Entities.  Trump has suggested cutting taxes on the owners of “pass-through” entities, such as S corporations, limited liability companies and partnerships, to 15%.  Under current law, the taxable income of such entities is passed through to their owners and taxed at the owners’ tax rates, which in the case of an individual could be as high as 39.6%.

Repatriation of Corporate Cash.  U.S. companies hold an estimated $2.5 TRILLION outside the United States (although Trump thinks it’s double that), which is currently escaping the U.S. tax system entirely.  Trump intends to incentivize such companies to repatriate these funds by taxing amounts that come back to the United States at a rate of 10% in a one-time repatriation program.

Elimination of Corporate “Tax Breaks”, But . . .   Trump proposes eliminating “most corporate tax expenditures.” However, one new corporate tax break is proposed.  Currently, capital investments must be expensed through depreciation deductions over a period of years.  The Trump Tax Plan would allow manufacturing companies to elect to immediately expense their capital investments in full in lieu of deducting interest expense.  This could strategically lower reported income and therefore income taxes for businesses.

Capital Gains Tax.  Long-term capital gains (on investments held for more than one year) will remain at the current rates of 0%, 15% and 20%.  In addition, short-term capital gains (on investments held for one year or less) will continue to be taxed as ordinary income, but subject to the new tax brackets.

Obamacare Taxes.  The Affordable Care Act imposes a number of taxes and penalties on both individuals and businesses.  Most significantly, it imposes a 3.8% Medicare surtax on net investment income.  This is one of the principal funding mechanisms for the program.  Trump has promised to repeal Obamacare and replace it with a program that is not funded by increased taxes.

Other Initiatives Impacting Personal Income Taxes.  Following are some of the additional initiatives Trump currently proposes that will impact personal income taxes.

• Carried Interests. In very simple terms, a carried interest is a kind of profit distribution that benefits partners and managers at investment firms, including those in private equity, real estate and venture capital.  A carried interest is often the principal element of the compensation of these partners and managers, and is currently taxed as capital gains.  The Trump Tax Plan would tax carried interests as ordinary income.

• Alternative Minimum Tax. This tax was initially intended to close “loopholes” that advantaged very wealthy taxpayers; however, the AMT has increased its reach, and now applies to many people whose income is higher than average but not extremely high.  The AMT reduces or eliminates various tax benefits that are available under the regular income tax, such as personal exemptions and payments for real estate and state taxes.  Taxpayers must figure their tax liability twice and pay whichever is higher: the AMT or the regular tax.  Trump proposes to eliminate the AMT.

• Estate Tax. This is a tax imposed on the transfer of assets from the estate of a deceased person to his or her heirs. The tax is currently imposed only if those assets exceed $5.45 million per individual.  Trump wants to abolish the estate tax completely.  However, the Trump Tax Plan would subject the decedent’s unrealized capital gains that have accrued as of the date of death to capital gains tax, but there would be a $10 million exemption.  Currently, the tax basis of each asset owned by a decedent is reset to its fair market value at the date of death, which means that unrealized capital gains in those assets are never taxed.

• Itemized and Standard Deductions and Personal Exemptions. The Trump Tax Plan would cap itemized deductions at $200,000 for married couples filing jointly and $100,000 for single filers.  The standard deduction for joint filers would be increased to $30,000 (up from $12,700 for 2017 under current law) and to $15,000 (up from $6,350) for single filers.  The personal and dependent exemptions deductions would be eliminated.

WHAT WILL HAPPEN?

Assuming all of the above reforms are enacted, the Internal Revenue Code will be in for its most significant overhaul since 1986.

U.S. Businesses Will Pay Lower Taxes, But . . .   As noted above, the current corporate tax rate is as high as 39%.  However, few businesses pay taxes at the highest rate because of the myriad ways the current law permits the rate to be reduced through deductions, credits, etc.  The tax rate businesses actually pay is called the “effective” tax rate.  Estimates of the current average effective tax rate that U.S. businesses pay range from 11% to over 30%.

Thus, while the implementation of a 15% business tax will reduce the income taxes paid by a significant number of business taxpayers, the overall reduction in taxes will in all likelihood be less than the proposed reduction from 39% to 15% would seem to indicate.

U.S. Businesses Will Have More Cash, But . . .   With the significantly lower tax rate, coupled with the repatriation program, it is likely that U.S. businesses will have more disposable cash in the United States.  It will be interesting to see how these funds are put to use.  The hope is that those funds will be used for hiring more workers, business reinvestment, and expansion.  However, many commentators believe that this “tax windfall” is more likely to benefit shareholders through stock buybacks and dividends, which is what happened when the U.S. initiated a repatriation tax holiday in 2005.

 The Very Wealthy Will Benefit the Most.  There are many studies which show that the more wealthy the individual, the more that individual will benefit from the Trump Tax Plan.  For example:

• The elimination of the estate tax will benefit estates valued at more than $5.4 million. Under current law less than one percent of the people who die each year pay any estate tax.

• People who are currently in the 35% and 39.6% tax brackets will pay only 33% under the Trump Tax Plan. The top tax rate applies to only taxpayers in the top one percent.

WHAT SHOULD YOU CONSIDER DOING NOW?

It is practically impossible to provide any meaningful guidance at this point because, as we said in the beginning, uncertainty reigns.  President Trump’s cabinet picks are apparently not in full agreement with his articulated agenda, and Trump himself vacillates on what he thinks should happen and how.  We believe, however, that Trump and the Republican majorities will make significant changes to the U.S. tax system in a way they believe will benefit the U.S. economy.

Questions? Call us.

The dispute resolution clause in a commercial contract is sometimes referred to as the “midnight clause” because it is often addressed at the end of contract negotiations (and many times after midnight) as an “afterthought,” with very little consideration given to its consequences.  Many times the lawyer drafting the contract will use whatever dispute resolution clause was used in the last contract he or she drafted, considering it to be a “standard” or “boilerplate” provision.  There is, however, no such thing as a “standard” or “boilerplate” dispute resolution clause.

Each dispute resolution clause should be carefully drafted to fit the needs of the parties and the deal which, among other things, involves taking into account the likely types of disputes, the parties’ long-term relationship, and the applicable laws.  Clearly, one size does not fit all, and a poorly drafted or incomplete dispute resolution clause can do more harm than good.  Paying attention to dispute resolution issues at the time the contract is drafted can avoid costly surprises later on, when the ability of the now disputing parties to agree on anything has diminished significantly.  It is a classic case of “you can pay me now or pay me later.”

The focus of this article is the arbitration clause in a domestic commercial contract in the State of Georgia.

Before You Decide on Arbitration – Know the Pros and Cons

Choosing to settle a given dispute by binding arbitration—rather than by litigating the dispute in court—is often perceived as having the benefit of being a less costly and more streamlined method of resolving the parties’ differences (although in recent years that has not always been the case).  However, when deciding whether to include an arbitration clause in a contract, the parties (and their attorneys) should bear in mind that it is extremely difficult to overturn an arbitration award in Georgia.  (Technically, a party cannot appeal an arbitrator’s award.  The party can instead apply to a trial court for an order to vacate or modify the award, but only on the very limited grounds specified in the Georgia Arbitration Code (“GAC”) or the Federal Arbitration Act (“FAA”).)  As stated by the Georgia Court of Appeals, “a litigant seeking to vacate an arbitration award has an ‘extremely difficult’ task.”  Because of this finality, before including an arbitration clause in a contract governed by Georgia law, it is very important that the consequences of such inclusion be fully understood by both the attorney and his or her client.

Fundamental Provisions To Include in an Arbitration Clause

Once the decision has been made to incorporate an arbitration clause into your contract, what should it include?  While each arbitration clause should be drafted to fit the needs of the parties and the deal, there are certain fundamental provisions that should be included in all arbitration clauses.

1.  Agreement to Arbitrate. The parties’ intent to resolve their disputes by arbitration should be clearly stated in the arbitration clause.  The arbitration clause should also state that any award will be “final and binding” to make it clear that the parties intend the award to be enforceable by the courts without any review of the sufficiency of the evidence underlying the award.

2.  Scope of Arbitration. The arbitration clause should be clear as to what types of disputes are subject to arbitration.  Ambiguity can result in protracted and expensive litigation over what is arbitrable.  This defeats one of the primary benefits of arbitration—avoiding litigation.  For example, if the parties want to limit arbitration to only certain types of disputes (e.g., contract disputes or disputes under a designated dollar amount), the arbitration clause should be drafted to specifically cover only such disputes.  On the other hand, if the parties intend that all potential disputes be arbitrated, including tort claims, fraud in the inducement, etc., the following language (or something similar) should be included in the arbitration clause: “All disputes arising out of, connected with, or relating in any way to this Agreement, shall be determined by final and binding arbitration.”

• Hybrid. Sometimes a contract will include a general arbitration clause as well as a more specific arbitration clause that covers, and may specify different terms for arbitration of, a very limited category of disputes.  For example, post-closing purchase price adjustment disputes in connection with the sale of a business are particularly well-suited for specific arbitration clauses.
• Arbitrability. Who decides disputes over the validity and enforceability of the arbitration clause itself or whether a particular substantive dispute is within the scope of the arbitration clause?  Under both the GAC and the FAA, the threshold question of whether parties to a contract have agreed to arbitrate a dispute is normally a matter for a court to decide.  However, if the parties have clearly and unmistakably provided in the arbitration clause that the arbitrator will decide questions of arbitrability, then the arbitrator has jurisdiction to decide them.
  • The American Arbitration Association (“AAA”) Commercial Arbitration Rules and Mediation Procedures (the “AAA Rules”), the JAMS “Comprehensive Arbitration Rules & Procedures (the “JAMS Rules”) and the Henning Mediation & Arbitration Service (“Henning”) Rules for Arbitration (the “Henning Rules”) all provide that an arbitrator has the power to rule on his or her jurisdiction.

3.  Choice of Ad Hoc or Administered Arbitration.

An ad hoc arbitration is one in which the parties have chosen to conduct the arbitration without the assistance of an arbitral institution, such as AAA, JAMS or Henning.  While ad hoc arbitration avoids the administrative fees charged by arbitral institutions (which can be substantial), the trade-off is that the parties will assume the administrative and planning responsibilities generally performed by the arbitral institution.

• For obvious reasons, ad hoc arbitration requires cooperation among the parties; however, the parties may not be in a cooperative mood after a dispute arises, which can be problematic. Without assistance from a neutral third party, the disputing parties often have difficulty reaching agreement on such basic procedural matters as the number of arbitrators, leading to undue delay and a possible lawsuit by one of the parties to move the arbitration along.
• In an ad hoc arbitration the parties will rarely want to negotiate dispute resolution procedures or rules from scratch; thus, the parties should consider designating ad hoc arbitration rules to provide a framework for conducting the arbitration, such as the 2007 Non-Administered Arbitration Rules (the “CPR Rules”) published by the International Center for Conflict Prevention & Resolution (“CPR”).

An administered arbitration is one in which the parties have chosen to conduct their arbitration with the assistance of an arbitral institution and pursuant to such institution’s procedural rules (referred to generically as “Arbitral Rules”).

• Arbitral Rules are neutral and self-executing; i.e., they provide for the arbitration to move forward despite the refusal of a party to respond to the initial arbitration demand or to appear at the hearing.
• Arbitral institutions generally provide administrative, logistical and secretarial support to the parties, and also handle the arbitrator’s fees and billing. Generally, with the exception of fee schedules, most Arbitral Rules allow the parties to vary the procedures set out in such rules.
• Not all Arbitral Rules are created equal. The choice of which arbitral institution will administer the arbitration is exceedingly important, as the arbitral institution’s Arbitral Rules will apply to fill in any “gaps” or terms on which the parties did not specifically agree when drafting the arbitration clause (g., the number and selection of arbitrators, the scope of arbitration, location of the arbitration, permitted discovery and motions, and the type and substance of the award issued by the arbitrator).  Each of the AAA Rules, the JAMS Rules and the Henning Rules may provide different outcomes with respect to any given situation.
• All of this comes at a cost. An arbitral institution typically will charge both a filing fee (which is often based on the size of the claim and any counterclaim), which must be paid in order for the arbitration to proceed, and a cancellation fee if the arbitration hearing is cancelled within a designated time period prior to its scheduled start date.  The filing and cancellation fees can be significant, and the difference in the filing and cancellation fees between some of the arbitral institutions can be staggering.

4.  Number, Selection and Qualifications of the Arbitrators. It is generally advisable for the parties to specify the number of arbitrators in the arbitration clause and how they will be selected.  The naming of a specific individual as the arbitrator should be avoided, since that person may not be available (or even alive) at the time of a dispute.  In almost all cases an arbitration will be heard before a sole arbitrator or a panel of three arbitrators.

• Some of the advantages of using a sole arbitrator are: it is generally easier and quicker to select one arbitrator than three; one arbitrator is much less expensive than three; and scheduling hearings is easier because there is only one arbitrator’s schedule involved. The final award also tends to be issued faster than with three arbitrators because there is no need to get input and agreement from the two other arbitrators.
• One of the primary advantages of having three arbitrators is that it lessens the chance of an “outlier” award; that is, having more than one arbitrator will tend to moderate an award, and the panel members are more likely to compromise their respective views in order to agree upon a final award.
• The parties may want to consider providing for one arbitrator for certain types of disputes (such as those under a designated dollar amount) and three arbitrators for all other disputes.

If three arbitrators are to be used, a common method of selection is the party-appointed method, in which each party selects one arbitrator, and then the two party-appointed arbitrators select the third arbitrator to serve as the chair.  Another method is the list method, in which the arbitral institution provides a list of potential arbitrators to the parties and the parties strike the persons they do not want and rank the remaining names in their order of preference.

One of the major advantages of arbitration is that the parties can specify in the arbitration clause the qualifications that a potential arbitrator should have (e.g., someone who is in the same industry as the disputing parties or has substantive knowledge in the disputed area), although too much specificity should be avoided because it can significantly reduce the number of qualified arbitrators.  This works well with three-member panels where it is possible to require that one of the arbitrators have certain qualifications (e.g., must be an accountant or engineer), which will ensure that the desired technical expertise is represented on the panel, while also having a chair with experience in the arbitration process.

5.  Location. The parties should agree to the location of the arbitration in their arbitration clause.  Under the FAA, the parties’ choice of a location for the arbitration must be honored; however, under the GAC the arbitrator has the power to choose the time and place of hearings despite the parties’ agreement.

6.  Interim Relief. Most Arbitral Rules provide that arbitrators can grant interim relief (e.g., a temporary restraining order) unless the arbitration clause limits that authority.  Be aware that a party can inadvertently waive its right to enforce an arbitration clause by engaging in actions that are inconsistent with the right to arbitrate, such as by applying to a court for interim relief before or during an arbitration.  While both the AAA Rules and the JAMS Rules provide that a request by a party to a court for interim relief will not be considered a waiver of a party’s right to arbitrate, the parties can avoid any confusion by specifically providing in the arbitration clause that a party does not waive its right to arbitrate by applying to a court for interim relief.

7.  Governing Law. Most commercial contracts include a choice of law clause that governs the interpretation and enforcement of the contract, although the law that governs the interpretation and enforcement of the arbitration clause can be different.  The FAA applies to arbitration clause agreements in connection with transactions involving interstate commerce, which generally include most arbitration clause agreements.  Georgia courts apply federal arbitration law whenever the dispute arises out of a transaction involving interstate commerce, and they  tend to exclude the use of any state arbitration law when the FAA is applicable.  However, a U.S. Supreme Court decision indicates that while the FAA preempts application of state laws that conflict with the federal policy favoring arbitration clause agreements, it does not necessarily preclude application of state procedural arbitration laws chosen by the parties and not in conflict with federal law and policy.

• Thus, if an interstate commerce contract with an arbitration clause provides that Georgia law will be the governing law of the contract, the GAC will apply to the arbitration to the extent it does not conflict with the FAA.
• The parties could also provide that Georgia law will be the governing law of the contract, but specify that the FAA will apply to the arbitration clause.

8.  Type of Award and Limitations on Awards. There are two main types of awards:

• a “standard award” (also called a “general,” “regular” or “bare” award) that includes only the relief granted and to whom, and does not include any reasons supporting the award; and
• a “reasoned award” that includes the reasoning of the arbitrator.

In practice, most awards are standard awards, and an arbitrator generally will issue a reasoned award only if required by the arbitration clause or the applicable Arbitral Rules.

In general, the cost of a reasoned award is considerably higher than the cost of a standard award, and the decision to require a reasoned award should not be made lightly, particularly when the amount in dispute is not significant.  However, whether the decision is to require – or prohibit – the issuance of a reasoned award, the parties should specifically include this decision in the arbitration clause, as the different Arbitral Rules can vary widely on whether the arbitrator must issue a “standard” or “reasoned” award if the arbitration clause is silent on this point.

Limitations on an award can be included in the arbitration clause.  The following two variations, which are typically used with monetary damage claims, limit the discretion of the arbitrator, prevent the dreaded “compromise” award, and in most cases are less expensive.

• “High-low” arbitration is where the parties agree to a range for the award but do not share the range with the arbitrator. An award over the “high” amount is reduced to that amount, and an award under the “low” amount is increased to that amount, but an award within the range is not adjusted.
• “Baseball” arbitration is a type of arbitration where each party to the arbitration submits a proposed monetary award to the arbitrator and to the other party. After there has been a presentation of evidence, the arbitrator will choose one award from the two submitted awards without modification.
  • A key element of baseball arbitration is the incentive for each party to submit a highly reasonable number, since this increases the likelihood that the arbitrator will select that number.
  • This type of arbitration has been used in Major League Baseball salary disputes for many years, and it has been increasingly used in commercial contract disputes in recent years, primarily when the parties’ dispute involves only a monetary amount.

9.  Entry of Judgment. Under both the GAC and the FAA, a party can have the award confirmed and made a judgment of the court.  While an arbitrator’s award is binding on the parties and does not require affirmation from a court to take effect, when a party refuses to abide by the award, confirmation and entry of judgment are essential for enforcement.

• In domestic commercial contract arbitrations, particularly under the FAA, the arbitration clause must contain an “entry of judgment” provision similar to the following: “Judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.”

Some Additional Provisions to Consider

In addition to the fundamental provisions discussed above, some additional provisions that should be considered are:

Costs and Fees.  Generally, unless the parties otherwise agree, the arbitrator may award the payment of the costs, fees and expenses associated with the arbitration (e.g., the arbitrator’s compensation and the arbitral institution’s administrative fee) against one of the parties or allocate the costs between the parties.

Attorneys’ Fees.  Under both the GAC and the FAA, an arbitrator has the power to award attorneys’ fees if the parties expressly agree in the arbitration clause.  Most Arbitral Rules allow for the allocation of attorneys’ fees if such allocation is stated in the arbitration clause or allowed by applicable law.

Interest.  If the parties want an award to bear interest, the best practice is to expressly authorize the arbitrator to award interest in the arbitration clause.

Punitive Damages.  The general rule is that an arbitrator can award punitive damages unless the parties expressly and unambiguously preclude such awards in their arbitration clause.  Thus, if the parties wish to prohibit the arbitrator from awarding punitive damages, specific language to that effect should be included in the arbitration clause.

Expedited Procedures.  In an expedited arbitration, the parties adopt procedures that significantly shorten the time from demand to award.  Both AAA and JAMS have rules and procedures for expedited/streamlined arbitrations and CPR has adopted fast track arbitration rules for ad hoc arbitrations.

Appellate Review.  The finality of arbitration awards is a significant benefit of arbitration; however, a significant drawback is the other side of the coin – the lack of meaningful court review of arbitration awards.  As discussed above, an arbitration award can be vacated only on very limited grounds, and errors of law, errors of fact, and errors of judgment are not grounds for reversal.

While the parties cannot expand the scope of review by the courts in their arbitration clause, it is possible to agree to broad appellate review by another arbitration panel.  JAMS and AAA have arbitration appeal procedures for awards issued by their respective organizations, and CPR has adopted appellate arbitration rules that can be used regardless of whether the original arbitration was conducted under the CPR Rules.  All of these appellate arbitration procedures and rules permit an appeal based on law and/or fact (similar to judicial appeals) to a panel of experienced appellate arbitrators.

Confidentiality.  Confidentiality is often assumed to be one of the primary advantages of arbitration.  However, and much to the surprise of many lawyers, while arbitration proceedings are in fact private, they are not necessarily confidential (e.g., an arbitration award enters into the public domain when an enforcement proceeding is commenced).  Thus, if the parties intend for the arbitration proceedings, documents and award to be confidential, this should be included in the arbitration clause.

Time Limits.  Whether due to business considerations or the desire to save costs, the parties may want to provide for time limitations in the arbitration clause.  These types of provisions require that the arbitration conclude within a certain number of days following the filing of the demand for arbitration or the appointment of the arbitrator, and/or require that the award be issued within a certain number of days following the closing of the hearing.  When time limits are used they should not be unreasonably short and the arbitration clause should make the time limits subject to adjustment at the discretion of the arbitrator.  This avoids putting the award at risk if the time limits are not met.

Scope of Discovery.  It is generally accepted that discovery is the primary driver of expense and delay in arbitration, and as arbitration has become more like litigation, the use of discovery in commercial contract disputes has increased.  Most, if not all, Arbitral Rules provide for some sort of limited discovery, and they empower the arbitrator to manage the discovery process.  In order to save hearing time, the parties may want to specifically allow for depositions in the arbitration clause, but with a limit on the number and duration of the depositions.  The parties should also consider eliminating or severely limiting interrogatories and requests for admission, both of which can be expensive and often fail to produce meaningful information.

Consider Limits on Dispositive Motions.  In arbitration, dispositive motions (motions seeking an order disposing of all or part of the claims of the other party without further proceedings) can cause significant delay and unreasonably prolong the discovery period.  Moreover, they are typically based on lengthy and expensive briefs, and dispositive motions involving issues of fact are generally denied, in part because one of the grounds for vacating an arbitral award under the FAA is the arbitrator’s refusal to hear relevant evidence.

However, dispositive motions can on occasion improve the efficiency of the arbitration process if directed to discrete legal issues, such as defenses based on statute of limitations or clear contractual provisions, in which case an appropriately framed dispositive motion can eliminate the need for expensive and time-consuming discovery.  As such, the parties should consider which dispositive motions should be allowed in an arbitration proceeding and then memorialize their understanding on this point in the arbitration clause.

Summary

Arbitration is a creature of contract, which means the parties can design the arbitration clause to fit their needs.  While it may be difficult during contract negotiations to look ahead to how the deal might fall apart in the future, investing the time up front to negotiate an effective arbitration clause could result in significant savings in both time and money in the long run.

Thinking about selling your business—eventually? Here’s some advice on how to maximize its value, reduce costs and minimize risks. (P.S. This advice is equally as useful if you’re not selling your business.)

As it turns out, business buyers are looking for the same things as business owners—sound businesses that produce predictable cash flows with quantified risks. (Who wouldn’t want that?) But what makes a “sound” business? A “predictable” cash flow? A “quantified” risk? These are subjective concepts ultimately intended to support the most tangible of outcomes: a factually-derived, cold, hard purchase price.

Because previous performance does not guaranty future results, financial performance is not the only factor helpful in determining a business’s value.  Buyers want assurances that past performance is likely to be repeated (and/or improved).  So, when valuing a business, buyers want to see tangible proof that the business’s valuable relationships and assets are protected and its risks are quantified (and, where possible, managed). This proof supports the proposition that past financial performance is more likely than not to be repeated or improved and gives buyers something tangible to “put their hands on” in valuing a target business. This proof allays buyers’ natural skepticism and allows corporate sales to be concluded cheaper and faster. So important is this proof that, we submit, creating and maintaining it increases a business’s value—whether or not the business is being sold.

So, what is this “proof”? That depends on the particulars of a given business’s valuable relationships, assets and risks.  What are the business’s sources of revenue?  Where does its money come from? Upon what assets and properties are the business’s cash flow dependent? What are the risks to that cash flow? To illustrate, let’s apply these principles to a hypothetical manufacturing business.

“Proof”—A Hypothetical Manufacturing Business

Our manufacturer obtains the bulk of its revenue from selling finished goods. What’s necessary for our manufacturer to continue producing cash flows from sales of finished goods? That depends on the particulars of this manufacturer. It could include intangible things like its relationships with customers, vendors and sources of raw materials, and unique manufacturing “know-how” that makes what or how they manufacture more valuable. It could also include physical assets, like its manufacturing facility, particularly if it is strategically located near customers or raw materials, so that it allows the manufacturer to save transportation costs and time, making its prices cheaper and its products faster to deliver than its competitors. The “proof” of these things (both intangible and physical) might include: customer and vendor contracts; proprietary trade secrets, confidential information or even patents supporting unique manufacturing processes; and the deed or lease for its manufacturing facility.

What are the risks to the manufacturer’s continuing cash flows? Again, these depend on the manufacturer’s circumstances. What if the manufacturer is threatened by an infringement lawsuit from a competitor? What if the long-term lease for its manufacturing facility is coming to an end? What if its source of supply for a key raw material is threatened? These things are important for assessing risks to the business’s ability to continue producing its historic cash flows. Proof of these matters would include copies of the infringement lawsuit and the contested patent or other intellectual property upon which such suit is based. It would also include files documenting the status of lease renewals or the search for an alternative location. Lastly, the manufacturer’s current raw material contract for the threatened source of supply would be critical, as would be contracts representing the status of negotiations or agreements to secure alternative sources of supply.

But what if there was no proof or paperwork documenting these relationships, assets or risks? What if the manufacturer relied upon its president’s personal relationships with vendors and suppliers, instead of having contracts with such parties? How would a buyer be able to evaluate the likelihood and strength of continued cash flows based on those relationships? What if the president intends to retire after the business is sold? What if the manufacturer has not filed applications for patents to protect its unique manufacturing processes or taken steps to protect the confidentiality of its trade secrets (making it very easy for another company to use those processes)?  What if the manufacturer has not secured written confidentiality obligations from its employees and contractors who are familiar with such matters (and who could take them with them when they leave)? What if there was no written lease for the manufacturing facility, but instead, the lease was based on a “handshake deal” between the manufacturer’s president and the lessor many years ago?

Such a lack of proof supporting valuable relationships and assets and allowing quantification of risks obviously makes cash flows much more difficult to predict. In fact, at some point, gaps in proof might make future cash flow predictions so tentative that a transaction, at any price, might not even be possible. Moreover, even if the business is not being sold, a lack of such proof increases the risk within which the business operates—and its value, even to the current owner.

It’s Time to Determine what “Proof” Your Business Has—and What It Needs

So, what should the prudent company executive do? Our recommendation is to:

• identify the assets, sources of revenue, critical relationships and risks unique to your business; then
• list the sources of “proof” that your business needs to maintain, support and quantify how these are likely to affect future revenues. (Don’t forget your business’s proof of its relationships with its most valuable resource—its employees.)

Once the business has listed the proof that it needs to maintain, it should then:

• identify areas where insufficient or no proof exists and begin documenting those matters to substantiate important relationships and assets;
• evaluate existing sources of proof to make sure they are adequate, up-to-date, organized, and available; and
• create systems allowing these proofs to be accessible, organized and secure.

Going through these procedures will cause the business to focus on those things that generate and maximize your business’s value—whether or not you are currently considering its sale!

Start Today. Some Areas of “Proof” to Consider

Below is an incomplete list of typical relationships, assets and risks that businesses might consider in evaluating their “proofs.” (Apply these to your unique circumstances before settling on the list of “proof” that is most relevant to your business.)

As you can see from this list, there are many things to consider when documenting—and thereby maximizing—proof of your business’s value. What’s important is that the business start developing this proof early and continue to identify where additional proof may be needed or improved.

If you need help identifying, prioritizing, creating, or improving the particular “proofs” for your business, we can help. Contact Scott Harris at Friend, Hudak & Harris, LLP.

Potential “Proofs” for Businesses to Consider

1. Customers: contracts with each customer; list of customers lost and added in the past three years; purchasing policies; credit policies; list of unfilled orders; advertising or marketing contracts, programs and materials; and list of major competitors.
2. Contracts with Third Parties: subsidiary, partnership or joint venture agreements; “insider” contracts between the business and officers, directors, shareholders and the business’s affiliates[1]; license agreements (both those for licensing of the business’s intellectual property to others, as well as those permitting the business to use intellectual property that it does not own); security agreements, debts, mortgages, collateral pledges, etc.; guarantees by or in favor of the business; installment sales agreements; distribution, sales representative, marketing or supply agreements; letters of intent or agreements relating to the purchase or sale, merger or consolidation of the business or its assets; agreements to purchase equity in other entities; contracts with customers, quotes, purchase orders, invoices and warranty terms; and non-disclosure or non-competition agreements to which the business is a party.
3. Products and Services: list of all products or services sold in the past three years or currently under development; tests, evaluations and other data regarding existing or developmental products or services; descriptions of all products and services, correspondence, applications and reports relating to regulatory application and approval for products and services; and descriptions of all complaints and warranty claims.
4. Legal Matters: articles of incorporation or organization and all amendments; bylaws and amendments; voting agreements; shareholder and/or operating agreements (whichever is applicable for the particular entity); stock ledgers and certificates, subscription agreements and shareholder lists; stock option, stock purchase plans and grant or award agreements under each; puts, calls, warrants, subscriptions and convertible securities; minutes of director, director committee and shareholder meetings (both annual and special meetings); certificates of authority to conduct business as an out-of-state company or LLC; list of all states and countries where the business has employees, property (whether owned or leased) and conducts business; annual company reports filed in each state; and list of all trade names and registrations for fictitious names.
5. Financial Information: last three to five years’ year-end balance sheets, income statements, statements of changes of financial position (whether audited or not); auditor’s and CPA’s letters and responses; most recent interim financial statements; list of all debts (both long- and short-term); credit reports; general ledger accounts; descriptions of internal control policies; and projections, budgets and strategic plans.
6. Real Property: list of all business locations; deeds; mortgages; leases (including renewals); title insurance policies; surveys; and zoning approvals, variances and use permits.
7. Personal Property: lists of all personal property of the business, describing the property, its type, location, and date of acquisition; motor vehicle registrations; all property leases, including vehicles; and list of capital equipment purchased or sold in the past three years.
8. Intellectual Property: lists of patents, copyrights, trademarks and service marks, and all registrations for same; list of trade secrets and confidential information of the business; any agreements or other documentation evidencing the business’s ownership of, or rights in, such intellectual property.
9. Employee and Consultants: employee lists with name, address, last three years’ salary and bonus, title, position description, initial employment date, and years of service; employment agreements; consulting agreements; non-disclosure, non-solicitation and non-compete agreements; invention disclosure and intellectual property assignment agreements; separation agreements; employee handbooks; lists of accrued holiday, vacation and sick day leave; employee benefit plans and their descriptions; workers’ compensation claims and history; discrimination, grievances, harassment, labor disputes, requests for arbitration, workers’ compensation, unemployment, and wrongful termination claims and history; list of all employee benefits plans, summary plan documents and descriptions of qualified and non-qualified plans; list and description of all health, welfare and disability insurance policies and self-funded plans; and collective bargaining agreements.
10. Licenses & Permits: business licenses; any governmental approvals, consents or permits; and copies of applications to, or proceedings before, regulatory agencies.
11. Environmental: for each property ever owned or occupied: environmental audits, list of hazardous substances, environmental permits and licenses; property owned or occupied; and lists describing all environmental litigation, investigations, liabilities or continuing indemnification obligations.
12. Taxes: copies of all foreign, federal, state, and local tax reports and returns for the last three to five years; sales and use tax returns; audit or revenue agency reports; tax settlement documents; employment tax filings; and tax liens.
13. Claims and Litigation: a description of any pending or threatened litigation; copies of insurance policies possibly providing coverage as to pending or threatened litigation; all documents relating to any injunctions, consent decrees, or settlements to which the business is a party; and list of any unsatisfied judgments.
14. Insurance: list and copies of the business’s general liability, personal and real property, product liability, errors and omissions, key-man, directors and officers, worker’s compensation, and other insurance policies; and list of insurance claims history for past three years.

[1] Which means any person or entity, controlling, controlled by, or under common control with, the company.