Using financial analysis

Attorneys and accountants rely heavily on financial reports when buying or selling a business, selling shares in their company, obtaining conventional and non-conventional financing, tax matters and on an unpleasant personal level in divorce by calculating maintenance, child support, and marital asset divisions. In smaller closely held businesses, the ability to manipulate the financial reports is present by business owners. The ability to read between the lines and perform a proper analysis and assessment of the quality of the financial statements is essential.

Table 5
Common Size Analysis
% of % of
2007 Revenue 2008 Revenue Change
Gross Revenue 250,000 100.00% 275,000 100.00% 0.00%
Cost of Sales 125,000 50.00% 130,000 47.27% 2.73%
Gross Profit 125,000 50.00% 145,000 52.73% -2.73%
Salaries 40,000 16.00% 45,000 16.36% -0.36%
Rent 10,000 4.00% 12,000 4.36% -0.36% 1
Selling and 60,000 24.00% 70,000 25.45% -1.45%
Administrative
Total Expenses 110,000 44.00% 127,000 46.18% -2.18%
Net Income 15,000 6.00% 18,00 6.55% -0.55%
Following are tips and areas to pay particularly close attention to when analyzing the quality of financial reports:

- Compare the company’s financial statements to the corporate income tax returns. Tax returns must be signed by the business owner and often give a higher level of assurance that the items reported are accurate.

- Look at interest and investment income. Is this appropriate for the level of cash and marketable securities reported on the balance sheet?

- Review bank reconciliation reports and cutoff dates. Does it appear that little or no deposits were made in December? Were the expenses in December higher than other months? Proper cutoffs can have a dramatic effect on both income and valuation purposes.

- Increased shareholder loans or receivables. Do changes in this account make sense and is the asset or liability properly divulged with the other financial disclosures?

- Acquisition of new debt. Request financial statements and pro-forma financial statements submitted with new loan requests to search for discrepancies or projections.

- Increases in fixed assets. Do these reveal discretionary purchases, which is one way to funnel funds into possible nonoperating or nonnecessary assets?

- Prepaid expenses. In cash-basis financial statements, the prepayment of expenses can decrease income and cash flow, thereby lowering entity value.

- Changes in operating expenses. Investigate changes in rent, legal fees, and other operating expenses to see if any of these key expense accounts have changed significantly from year to year.

- Changes in officer or key employee salaries. Is the amount being paid in line with the level of service being provided? Is it fairly consistent from year to year? In some cases, key employees may be given bonuses, additional expense allowances, new cars, or other perquisites as an attempt to lower firm income and cash flow.

- Changes in cost of goods sold. This account tends to be a “catch-all” and a perfect place to hide nonoperating and nonbusiness expenditures. Perform a common size analysis on the income statement to confirm that the overall percentage of cost of goods sold is in line with the prior year.

- Nonoperating, appreciating assets. Does the company own any artwork, real estate, investments in other companies, or marketable securities? These assets are reported at their original cost, and their appreciation is not reflected on financial statements.

- Allowance for bad debt. Is this reasonable? Is it comparable to other competitors in the industry? Has the company employed new collection techniques that may render this estimate incorrect?

- Discretionary costs. Look for lavish expenditures, sporting events, travel, and entertainment. Are these necessary for the operation of the business? Are they comparable to prior years and other similar businesses?

- Off-balance-sheet assets and liabilities. For some companies, the value of an enterprise is not fairly represented in financial statements. For example, in a startup company, the entity may show negative cash-flow, but the value may lie in the research and development of new processes, patents, trademarks, etc. Are investments in real estate and other personal property, such as artwork and collectibles, worthy of further investigation?

These are most of the fundamental concepts related to using financial statements of any business enterprise for your own purposes. Whether you are buying or selling a business, trying to get financing or are getting a divorce, knowing what the numbers mean can save you a lot of money. Not understanding the financial health of an enterprise can (and most likely will) cost you a sizable amount of money. Too often small business owners don’t want to take the time to learn or expend the effort to understand the financial position of their own company, often pushing the responsibility of it to their accountant or banker. When owners fall into this habit, they are totally dependent on third parties about a crucial part of operating their business and will be making decisions based on incomplete information.

Besides, if you look at past business owners who became very wealthy and successful business owners you will find that virtually all of them had a complete understanding and the ability to look at the numbers and know what they mean.

An independent Certified Public Accountant (CPA) can provide three levels of services related to the financial reporting of a business enterprise. These are a compilation, review, and an audit.

A compilation provides the lowest level of assurance. A compilation engagement is the most common for small closely held businesses because it is the least expensive and requires less time because of fewer procedures. A compilation consists of assembling the financial data from the company’s accounting records and presenting it in the form of financial statements. The financial information is strictly the representation of management, and the accountant is not required to perform any procedures to verify or corroborate the financial-statement information provided by the client. The accountant is required to read the compiled financial statements and consider whether they are in appropriate form and free from obvious material errors.

A review is an evaluation of a company’s financial statements using management inquiries, analytical procedures, and a knowledge of the industry. The scope of a review is less than an audit, but it provides “limited assurance” that nothing came to the accountant’s attention requiring modification. A review engagement requires all of the procedures necessary for a compilation engagement plus other procedures that enable the accountant to provide limited assurance on the financial statements.

An audit engagement provides the highest level of assurance about the reliability of a company’s financial statements. This service is a critical review and verification of financial data. An audit results in a professional opinion from the CPA, attesting to the accuracy of the financial statements and the representations they contain. In addition, the CPA is required to obtain reasonable assurance that the audited financial statements are not materially misstated due to fraud.

Financial statement analysis

An important part of any business analysis is a comparison of the financial performance of the subject company to benchmark data available in the marketplace. This data can be obtained from a number of sources and is usually segregated by industry. Ratio analysis compares the performance of a company to that of its peers by eliminating the element of size. Some of the categories of ratios are:

- Liquidity

- Profitability

- Leverage

- Activity

- Investment

Liquidity–These ratios measure a company’s ability to pay its short-term financial obligations. Normally, the higher the ratio, the better, as this indicates a company’s ability to fund operations while covering maturing debts. If too high, however, the company may have too much cash and should be making distributions, investing in operating assets, paying down long-term debt, etc. A low ratio can indicate a company’s difficulty paying its obligations.

The most commonly used liquidity ratio is the current ratio:

Current ratio = Current assets/Current liabilities

Generally a current ratio of 1.0 or greater is considered good, but this can vary by industry

Profitability–These ratios indicate how the company has operated over the past year. They demonstrate how successful the company was in generating profit and increasing shareholder value. These ratios are frequently used to gauge the effectiveness of management.

Operating profit margin = Earnings before interest and taxes/sales

Net profit margin = Earnings after taxes/sales

Return on assets = Earnings after taxes/total assets

Leverage–Also known as coverage ratios. These ratios measure the coverage for long-term lenders and investors. They provide information regarding the company’s overall debt as well as its blend of debt to equity. These ratios can be used to determine the overall financial risk of a company.

Long-term debt-to-equity ratio = Long-term debt/shareholder’s equity

Interest coverage = Earnings before interest and taxes/interest charges

Table 4
Cash Basis v. Accrual Basis
Cash Basis Accrual Basis
Assets
Cash $ 50,000 $ 50,000
Accounts Receivable – 25,000
Property and Equipment 80,000 80,000
Less Accumulated (40,000) (40,000)
Depreciation
Other Assets 10,000 10,000
Total Assets 100,000 125,000

Liabilities and Equity
Liabilities
Accounts Payable – 15,000
Long-Term Debt 25,000 25,000

Equity
Retained Earnings 25,000 25,000
Current Period Net Income 50,000 60,000
Total Liabilities and Equity 100,000 125,000

Revenues 200,000 225,000 (a)
Less: Expenses 150,000 165,000 (b)
Net Income $ 50,000 $ 60,000

(a) Cash Basis Revenue 200,000
Accounts Receivable 25,000
Accrual Basis Revenue 225,000

(b) Cash Basis Expenses 150,000
Accounts Payable 15,000
Accrual Basis Expenses 165,000

Activity–These ratios measure the effectiveness of management to utilize the assets and other resources of the company. These ratios measure how well a company converts its assets into revenue.

Receivables turnover = Credit sales/accounts receivable

Asset turnover ratio = Sales/total average assets

Investment–Investors use these ratios to evaluate potential or existing investments in comparison with others to determine their value.

Price-to-earnings ratio = Stock price/earnings per share

Another procedure to evaluate a business enterprise is through the use of a common size analysis. This is a process whereby each item on the balance sheet and income statement is restated as a percentage of a given base. Balance sheet items are usually restated on a basis of total assets and income statement items on a basis of total revenue.

Cash-flow statement

The statement of cash flows reports a company’s sources and uses of cash. These sources and uses are broken down into three distinct categories:

Operating activities–cash from the operations of the business. Generally starts with net income for a particular period and is adjusted for noncash items such as depreciation and amortization.

Investing activities–cash from the purchase and sale of property and equipment. Also includes cash used for investments in other assets.

Financing activities–includes cash received from borrowing and repayment of debt. It includes the payment of dividends and distributions to shareholders and owners and the issuance and retirement of equity capital.

The Table below, is the statement of cash flows and starts with net income as reported in the income statement. The ending net cash also ties to the cash reported in the current asset section of the balance sheet at left.

Table 3
ABC Firm, Inc.
Statement of Cash Flows
For the year ending December 31, 20__

Cash flow from operating activities
Net income from Operations $ 145,470
Add Noncash Expenses:
Depreciation 1,500
Total Cash from Operating Activities 146,970

Cash from Investing Activities
Purchases of Equipment (20,000)
Cash from Sale of Equipment 2,500
Cash from the Sale of an Investment 1,660
Total Cash from Investing Activities (15,840)

Cash from Financing Activities
Cash from New Debt 13,000
Cash Used to Pay Debt (15,000)
Cash Paid to Shareholders or Partners (107,630)
Total Cash from Financing Activities (109,630)

Total Increase in Cash 21,500
Beginning Cash Balance 5,000
Ending Cash Balance $ 26,500

Basis of accounting

Small businesses have the option of reporting their financial statements on a cash basis or an accrual basis of accounting. The main difference between these two is when underlying economic activity is recorded in the general ledger and reflected within the financial statements.

In cash-based accounting, revenue is recognized when payment is received from the customer, not when the customer is invoiced. Expenses are recognized when cash is disbursed, not when a bill is received from the vendor. This basis of accounting is most popular for income tax reporting because it delays the recognition of income from accounts receivable until it is actually collected.

In accrual-based accounting, items of income and expense are recorded as earned or incurred, respectively, regardless of when cash trades hands. This method is preferable to the cash basis of accounting and is required under GAAP. It is preferred because it complies with the “matching principle,” which states that income and expenses for a particular period should be matched, regardless of when the cash is received or disbursed.

Table 4 reveals the effect of using cash basis versus accrual basis accounting:

Another important basis of accounting is what is referred to as tax basis. Tax basis issues are important in the context of fixed-asset transactions, as well as in other areas, such as ownership investments in the enterprise.

Liabilities

The liabilities of an enterprise can best be described as the claims against the assets of the enterprise. As is the case with assets, liabilities are segregated between current and noncurrent categories, with current being those liabilities that can be expected to be satisfied within one operating cycle, normally considered to be one year.

Current liabilities–amounts owed that will be paid within one year. Includes accounts payable, accrued payroll liabilities, and the portion of long-term debt that will be paid within one year.

Long-term debt–amounts owed that are not expected to be paid within one year.

The equity section of the balance sheet represents the claims of ownership against the assets of the enterprise. Equity is what is left after the satisfaction of third-party claims. The efficient deployment of assets to create equity is the challenge of every business enterprise. Understanding the relationship between the application of assets and use of liabilities to increase returns on equity is the essence of sound financial management.

Common and preferred stock–securities that represent ownership in a business enterprise. These are reported at their stated par value. If the par value is zero, this account may not appear on the balance sheet.

Additional paid in capital–the amount paid for common or preferred stock that is in excess of its stated par value.

Retained earnings–represents the earnings of a business enterprise that have not been distributed to the owners in the form of dividends or distributions.

Income statement

The income statement is commonly referred to as the statement of operations, profit-and-loss statement, or statement of revenues and expenses. It conveys the performance of an enterprise over a specific period of time. The income statement of the company reflects the success of the enterprise in the inflow of revenue in relation to the outflow of expenses. Such information is essentially a roadmap between balance sheet dates.

Revenues (sales)–inflows of assets from the production and sale of goods, the rendering of services, or the performance of other activities that constitute the entity’s primary operations.

Cost of goods sold–costs incurred that relate directly to the production of goods and services.

Gross profit–revenues less cost of goods sold.

Operating expenses–uses of assets in the operation of a business. These include general and administrative expenses, rent, officers’ wages, legal and professional fees, etc.

Table 1
ABC Firm, Inc.
Balance Sheet
December 31, 20__

Assets
Cash–Operating $ 25,500
Cash–Payroll 1,000
Accounts Receivable 42,200
Current Assets 68,700

Furniture, Fixtures & Equipment 228,600
Software 4,850
Leasehold Improvements 84,100
Less: Accumulated Depreciation (69,700)
Total Fixed Assets 247,850

Organization Costs 2,500
Less: Accumulated Amortization (1,160)
Total Intangibles 1,340

Deposits 11,200
Other Assets 25,000

Total Assets $ 354,090
Liabilities
Accounts Payable $ 58,350
Accrued Payroll Liabilities 11,100
Accrued Interest Due ABC Bank 1,100
Current Liabilities 70,550

Note Payable–ABC Bank 220,000

Total Liabilities 290,550

Common Stock 1,000
Additional Paid in Capital 8,000
Dividend Payments (107,630)
Retained Earnings 16,700
Current Net Income 145,470
Ending Equity 63,540

Total Liabilities and Equity $ 354,090

Table 2
ABC Firm, Inc.
Income Statement
For the year ending December 31, 20___

Revenues
Sales Income $ 800,000
Less Cost of Goods Sold (275,000)
Gross Profit 525,000

Operating Expenses
Salaries & Wages 275,750
Rent 62,200
Employee Benefits 22,200
Common Area Maintenance 4,450
Storage 2,450
Client Development 2,300
Depreciation 1,500
Postage and Delivery 800
Dues and Subscriptions 700
Total Operating Expenses 372,350
Net Operating Income 152,650

Other Income and Expenses
Interest Income 420
Gain from Sale of Fixed Assets 2,500
Interest Expense (1,800)
Charitable Contributions (8,300)
Total Other Income/(Expense) (7,180)

Total Net Income $ 145,470

Nonoperating income and expenses–these are income and expense items that are not directly related to the primary operating purpose of the business. Examples are investment income, interest expense, and unusual gains and losses.

A critical element in understanding how to comprehend the information conveyed in the balance sheets and income statements of any enterprise is to understand the linkage between these two primary statements. The income statement can be viewed as an expanded picture of the changes in balance-sheet equity derived from business operations. Retained earnings is the summary of all net income less distributions of profit from the inception of the entity. The change in retained earnings on the balance sheet is essentially the net result of the entity’s revenue less expenses between balance sheet dates, less the distributions of such net profits for the period. This is a complex concept to grasp, but it is the critical linkage between the activities reflected in the two primary financial statements.

We all know of the relatively recent, devastating effects of the corruption and fraud in the financial reporting of industry giants such as Enron and WorldCom. These companies were able to defraud investors at a level never seen before primarily through the systematic manipulation of their financial reports. Although in most matters we are not dealing with multibillion-dollar enterprises, it is still critically important to gain a general knowledge of how financial statements are created and what information can and cannot be obtained from these resources.

The primary objective of financial reporting is to communicate understandable information useful to the reader. To achieve this objective, the information must be accurate, timely, and in the proper format. The standard framework for guidelines and procedures in the United States for financial reporting is Generally Accepted Accounting Principles (GAAP), which includes mandatory standards, conventions, and rules that must be followed when reporting financial data for certain entities such as publicly held companies. In many instances, however, alternative methods of accounting will be utilized, including the cash basis and modified cash basis of accounting.

Regardless of the accounting method used, the financial statements of a company are the end product of the accounting process and include three primary reports:

Balance sheet

Income statement

Cash-flow statement

These three reports can provide valuable information regarding the financial status of an organization. It is important to understand how these statements work together to paint a picture of the overall health and financial position of the enterprise. It also is important to understand how the presentation of the financial information can differ from one organization to the other.

The balance sheet

Often referred to as the statement of assets, liabilities, and equity, or the statement of financial position, the balance sheet represents a company’s economic status at a particular point in time. It is considered a “snapshot” of the company’s financial condition as of a certain date, usually the end of a month or year. Changes in the balance sheet from period to period can give a great deal of information about the enterprise.

The balance sheet equation consists of assets being equal to liabilities plus equity:
Balance Sheet Equation
Assets = Liabilities + Equity

The economic resources of an enterprise can consist of both tangible and intangible assets. Assets are current and non current items of value and include tangible items such as cash and cash equivalents, accounts receivable, inventory, fixed assets, and prepaid expenses. Intangible assets are items such as intellectual property and goodwill.

An organization’s assets are presented on the balance sheet in order of their liquidity.

Current assets–cash or other assets that can be converted to cash within one year. Examples are cash, accounts receivable, inventory, and prepaid expenses.

Property and equipment–used in the operations of the business, shown at historical cost with a reduction for accumulated depreciation. Examples are machinery, equipment, office furniture, computers, and leasehold improvements.

Other assets–that don’t fit into the first two categories. These often include intangible assets such as trademarks, patents, and purchased goodwill.

An important accounting convention relates to the carrying values for balance sheet assets and liabilities. GAAP require financial statement values to be recorded and carried at historical costs, which are the initial costs incurred when the items are first transacted.

In many instances, some of the economic resources of the enterprise will not be shown on the balance sheet, such as the value of an entity’s proprietary processes, the value of customer lists and relationships, or the benefits of having an established, well-trained workforce in place.

An S corporation must be a small business corporation, which can have only one class of stock. If an S corporation issues a second class of stock, it ceases to meet the definition of a small business corporation, and its S corporation status is automatically terminated triggering significant adverse tax ramifications for its owners.  A corporation that has issued only one class of stock may conduct its business or enter into agreements that treat certain shareholders or creditors in a manner that causes the company’s actions/agreements to be considered a second class of stock.

The one-class-of-stock rule prevents the corporation from having the complexity related to  allocating earnings to multiple classes of owners.  A corporation has only one class of stock if all outstanding shares provide for identical rights to stockholders regarding distribution and liquidation proceeds.  However, differences in voting rights among shares of stock of a corporation do not automatically indicate that there is more than one class of stock.

A corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.  Relevant to a determination of whether all outstanding shares of stock are of the same class requires that the stock confer identical rights to distribution and liquidation proceeds (versus voting rights) and is based on the terms of the articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds.

An Interesting Case.

A shareholder used the second-class-of-stock rule in a court case when the shareholder’s parents had a janitorial and paper-supply company that elected S status.  As the shareholder’s parents aged, the shareholder and her brother took control of the company, each owning half of the stock.  The corporation retained most of its earnings, but did distribute enough dividends to enable shareholders to pay their personal income tax on their shares of corporate income.  The corporation suddenly stopped making the tax-payment dividends, leaving the shareholder with substantial income tax liabilities and no company distributions to cover the taxes. The shareholder knew this was part of an effort by the father and brother to squeeze the shareholder  out of the business.

As a stockholder, the shareholder took a very unusual position: that the S election had been lost, and the tax on corporate earnings be imposed on the corporation rather than on the shareholders. According to the shareholder, certain extra payments made to the parents from the S corporation indicated that the parents had preference as to dividends.  This preference meant there was a second class of stock.  If the shareholder won, then the S election had been lost and no taxes would be owed.
The court found little evidence on which to base a conclusion regarding the nature of the extra corporate payments to the parents. The shareholder was unable to meet the burden of proof needed to show that there was a second class of stock and was liable for the income taxes.  Too bad for the shareholder, but an interesting legal argument since shareholders rarely try to terminate an S election as they usually fight to maintain it.

Situations that create a second class of stock.

1.  S Corporation has a binding agreement with its shareholders to modify its normal distribution policy by making upward adjustments of its distributions to those shareholders who bear heavier state tax burdens. The adjustments are based on a formula that will give the shareholders equal after-tax (i.e. after state tax) distributions. The agreement relates to distribution or liquidation proceeds and is a governing provision that alters the rights conferred by the outstanding stock of S to distribution proceeds therefore, those rights are not identical thereby treating the company as having more than one class of stock.

2. Interest on debt is paid only if the corporation has earnings, or is interest payments are tied in some way to dividend policy. The corporation may be treated as having more than one class of stock.

Cases that typically do not create a second class of stock.

The IRS regulations list the following situations that do not involve a second class of stock.   Caution is advised, because the result may be different if the circumstances indicate there is an attempt to avoid the one-class-of-stock requirement, etc. When in doubt seek appropriate counsel.

1. Straight Debt. Debt is not treated as a second class of stock if: it is a written unconditional obligation, regardless of whether embodied in a formal note, to pay a sum certain on demand, or on a specified due date; it does not provide for an interest rate or payment dates that are contingent on profits, the borrower’s discretion, the payment of dividends with respect to common stock, or similar factors; It is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; it is held by an individual (other than a nonresident alien), an estate, or certain trusts.

2. Debt held proportionately. Obligations of the same class that are considered equity under general principles of federal tax law, but are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation, are not treated as a second class of stock.

3. Buy-sell agreements. Agreements among shareholders restricting the transferability of stock, are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation.

4. Redemption Agreements. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.

5. Fringe Benefits. S Corporation is required under binding agreements to pay accident and health insurance premiums on behalf of certain of its employees who are also shareholders. Different premium amounts are paid by S Corporation for each employee-shareholder. S Corporation is not treated as having more than one class of stock.

6. Employment Agreements. A and B are shareholders of S Corporation. A is also an employee of the company. By agreement, the company will redeem A’s shares on the termination of employment. The agreement is disregarded in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.

7. Change in Stock Ownership. An S corporation governing instrument provides that the amount of distribution will be adjusted to take into account the fact that a stockholder owned stock for less than the full year. The corporation is not treated as having more than one class of stock.

Voting Rights

The Subchapter S Revision Act of 1982 added the flexibility of allowing a company to issue voting and non-voting stock without running afoul of the one-class-of-stock requirement. Voting stock may be given to those family members who are most qualified to run the business, with non-voting stock given to other family members. However, the stock must have the same rights to distributions, or the S election will be lost.

Given the impact that losing an S election can have on a company and its shareholders, one is well advised to seek counsel before undertaking matters that could cause the loss of the election.

In response to corporate abuses at Enron, Tyco and other companies, militant shareholders in both public and private companies are increasingly trying to hold management and directors accountable for their actions (not a bad thing at all).  The bottom line of any of this type of activism is that directors and officers are held to elevated expectations and greater scrutiny of their performance.

In making decisions on behalf of the company, directors (and officers) are held to two duties: one of care and the other of loyalty.  If directors and/or officers comply with these duties, the decision is protected by “the business judgment rule,” a standard of court review where courts will defer to a decision unless there is palpable evidence that the parties have ignored or breached their duty of care or loyalty.  Directors may also breach their duty of oversight by failing to make a decision at all; that is, by not acting to hold management accountable for their actions.

Key board decisions, such as whether to sell the company or issue or redeem stock present the possibility that the board may not be acting in the best interests of the shareholders but instead to entrench itself in power.  The Delaware Courts sent a message in In re The Walt Disney Co. Derivative Litigation case by not dismissing claims that the board members were grossly negligent in approving key executive compensation agreements.  While the directors were eventually exonerated the series of decisions in the Disney litigation highlighted the importance of corporate minutes.

The Necessity of Maintaining Accurate Minutes

Corporations are required by law to keep accurate books and records, and specifically to prepare and maintain minutes recording the proceedings of any meetings of directors and shareholders.  Regularly maintaining corporate minutes is also a key component of observing corporate formalities, which is essential to recognition of the corporate form.  Failure to observe these formalities can result in creditors “piercing the corporate veil” and imposing liability on the shareholders for corporate obligations.

Minutes are prepared not just for internal use but also for review by third parties such as shareholders.  In addition to shareholders, those who may seek to review corporate minutes include underwriters in connection with due diligence reviews for capital raising transactions and buy-side counsel in connection with sale, merger or acquisition.

In re NetSmart Technologies, Inc. Shareholders Litigation is a poster child for poor minutes preparation practices in connection with a critical decision such as the sale of the company.  The case illustrates how courts focus on relevant minutes to determine whether the board complied with the heightened standards that apply to significant corporate transactions, such as a merger, the need for consistency between the minutes and the disclosure documents describing background events in such transactions, and the importance of preparing and approving minutes promptly (and properly) while events are still fresh in the minds of the directors who were present.

Responding to overtures from private equity buyers, the NetSmart board formed a special committee to oversee a rapid auction process among identified private equity bidders that led to execution of a cash merger agreement with the winning bidder.  Shareholders complained that the agreement was the result of a defective sales process because it excluded strategic buyers and that the proxy statement omitted material information.  The Court noted that once the board determined to sell the company for cash, it had a duty under Revlon to secure the highest price realistically achievable given the market for the company.  Concluding that the plaintiff’s had established a reasonable probability of success on the merits of two of their claims that the board had failed this standard, and the court preliminarily enjoined the shareholder vote on the merger to provide time for the defendants to amend the proxy statement to respond to the plaintiff’s disclosure claims.

The court was highly critical of the company’s minute-taking practices.  It pointed to a May 19 meeting, described in the proxy statement as an informal board meeting because no minutes were taken, where a determination was made to attempt to sell the company and to focus on private equity buyers without an active canvass of strategic buyers.  The court noted that no minutes were taken at a July 13 meeting to consider an acquisition proposal, also referenced in the proxy statement, held by a special committee created by the board.  Thus, if the board had, in fact, considered carefully and rejected the option of opening the sale process to strategic bidders, the absence of minutes clearly recording such deliberations greatly impaired the directors’ ability to make that argument.

As you can see properly drafted minutes are an important part of owning or running a corporation and should not be dismissed as merely a lawyer’s fetish.  Ask yourself a question; are the potential consequences of failing to keep accurate, well drafted minutes worth taking a chance on?  Would you bet your company on it?

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.