Private Business Counsel

Managing expenses is an issue for every business, but it is particularly an issue for small and closely-held businesses.  For very rational reasons, exercises that might otherwise seem sensible, but for which there is no clear and quantifiable benefit, are typically put to the side for future consideration, or simply not undertaken at all.  Like callers on hold, issues are addressed in the order in which they arise.

We see this fairly frequently when it comes to corporate record-keeping.  Under the laws of nearly all US jurisdictions, certain corporate actions require the approval of the board and/or shareholders.[1]  This applies to both corporations and LLCs. These actions include:

• the appointment and re-election of officers and directors;
• entering into certain transactions such as sales of assets and borrowings of money;
• issuances of equity;
• amendments to governing documents; and
• approvals of transactions between the company and related persons.

Records of these approvals are typically kept in corporate minute books, which include records of board and shareholder meetings and actions by written consent.  Other important records include stock books (including stock ledgers and copies of stock certificates), copies of tax returns and elections, and copies of signed contracts and other documents that are important to the business.

Of course, there is no outside “watchdog” that requires the maintenance of these records, no fines that are levied if you don’t follow these rules.  Thus, if a company is being run in a bona-fide manner (i.e. it is adequately capitalized and being run as a business and not as a personal expense account), and if ownership is all “in the family”, so to speak, one might determine that there is little cause for concern.  In other words: no harm, no foul.

Though this reasoning is understandable, we do not think it is well-advised, for two reasons.  The first is that the potential benefits of good record-keeping are larger than one might think.  The second is that the expenses of good record-keeping are small.  Both are discussed in turn.

Benefits of Good Corporate Record-Keeping.  The potential benefits of good record-keeping (and the costs of bad record-keeping) typically bear themselves out at the time a business is sold.  If a business is being sold to a third party buyer at a valuation of any significance, that buyer will conduct extensive due diligence; and one of the items we see at the top of every buyer’s due diligence request list is access to the company’s corporate records.

Why does a buyer need to see the corporate records?  One reason is that in a deal structured as a “stock deal” (i.e. a deal in which the buyer buys all the outstanding equity of the company), the buyer is, in effect, inheriting all the corporate attributes of the company.  If the company has not maintained adequate corporate records, the limited liability of the company’s shareholders – one of the biggest reasons why companies are formed to be begin with – can be called into question.  Now, the risk of this actually happening is mostly theoretical, and a lot of this can be fixed in connection with the closing of the transaction.  But that fix requires the time and effort of lawyers and internal personnel.   That time and effort, of course, costs money, and the costs of doing all of this after the fact are significantly greater than doing it in real-time.  These increase costs are borne by the seller at the closing table in the form of transaction expenses.  Getting this all done in advance avoids this unnecessary expense.

In a stock deal, inadequate record-keeping can also make a buyer uncertain as to whether it is purchasing all of the equity of the company.  This issue can arise if the company is missing stock certificates that relate to repurchased or transferred shares, or has not maintained a current, up-to-date stock ledger, or has not maintained records of board approvals regarding share transfers.  These issues are less fixable, and go to the heart of the deal the parties are trying to make happen.  They can lead to a number of bad results for the seller: a purchase price decrease, more closing proceeds put into escrow, a restructuring of the transaction, or, in the worst case scenario, the collapse of the deal altogether.

Other reasons buyers want to review corporate records have to do with the specifics of the company in question.  Here are some examples:

• If the company is taxed as an S-Corporation and cannot demonstrate its compliance with the various rules regarding S-Corporation, this could undermine the basis on which a buyer is willing to proceed with the transaction, and result in a lower purchase price.[2]
• If the company has a good deal of contracts and does not keep complete records of those contracts (including signed copies and all exhibits, work orders, appendices, etc.), the buyer may not get comfortable that it’s getting enforceable, contractual relationships, even if those relationships are going just fine for the company from a business perspective in the absence of such records.
• If intellectual property is an important asset of the company, the buyer will want to see whether all IP registrations have been maintained and paid for, and whether all of the company’s employees have signed assignment agreements with respect to intellectual property created while in the employ of the company.

As most sellers of a business can attest, the due diligence process in a sale transaction is always a time consuming, costly and arduous process.  However, good record-keeping can make this process far more efficient, and can help make an exit transaction suitable for a business owner remain that way.

Costs of Good Corporate Record-Keeping.  So, how much does it cost to keep your corporate records in order?  In short, the answer is very little.  Particularly for closely-held companies, the effort is modest.  The writing up of minutes of board and shareholder meetings does not take a particularly large amount of time (particularly for routine matters), and the maintenance of a complete stock ledger is simply a matter of getting a correct set of records established and then keeping it current.  You might engage outside counsel to do this for you (and this can be done at very reasonable rates), or you might decide to do this yourself (though you will want to at least consult an attorney at the outset, just to know what it is you should be doing).

However you decide to do it, keeping good corporate records in real-time makes this effort much easier and less costly.  And when it comes time to sell your business, you will be glad you did it.

[1] This post applies to both corporations and LLCs, and the use of the terms “shares” and “shareholders” are meant to include their LLC equivalents, “members” and “units.”  While the rules applicable to LLCs are somewhat less stringent than the rules applicable to corporations, the benefits of adequate record-keeping apply to both types of entities.

[2] A future blog post will get into some of the technical details that apply to sales of S-Corporations.