Get on Board: The Sarbanes-Oxley Act’s impact is felt throughout corporate America – even if you’re private

Though Sarbanes-Oxley applies to public companies, exit planning of private companies should include independent boards and auditors and corporate transparency.


Darwin Magazine , April 2003

By Robert A. Adelson

Are you the founder, CEO or COO of a growing early stage company?  Are you thinking down the road toward exit strategy?  Is your goal an acquisition or IPO?

If so, beware.  New corporate governance rules have changed the culture for emerging companies.

Currently, the new rules, collectively known as the Sarbanes-Oxley Act, are biding on public companies only.  These rules, however, represent “best practices” that can impact your private company as you position for future exit strategy and compete for capital, talent and commercial opportunities in difficult times.

Most important, these rules will influence your need for building a strong board of directors.

The Sarbanes-Oxley Act

Over the past year, numerous corporate scandals have exploded on the marketplace stunning investors and the general public alike.  Enron, Worldcom, Qwest Communications and Global Crossing were just a few of the corporations to come under SEC investigation during 2002.

Such an unprecedented number of corporate follies sparked a public cry for corporate reform legislation that was answered by the enactment of the Sarbanes-Oxley Act on July 30, 2002.  Addressing the need for a more accurate admission of public company’s financial records, Sarbanes-Oxley tightens regulation through five main areas of corporate governance:  disclosure, board of directors, auditors, ethics and compensation.

Taken one by one, they are:

  • Disclosure: Company management is now required to evaluate and report on the effectiveness of its “internal control structure and procedures” concerning financial disclosure.  While the new rules increase disclosure and decrease filing time for former 10-K, they also enhance the difficulty and costs of private companies to get audits completed in a timely fashion and sent to investors.
  • Board of Directors: NASDAQ and NYSE have proposed rules to the SEC requiring the board of directors to have at least a majority of “independent” directors.  Under the new rules of the Sarbanes-Oxley Act, independent is narrowly defined as being truly autonomous from the business.
  • Auditors: All auditing members must be completely independent and not entangled within the business.  A higher standard is set for financial expertise, with a director who will act as the “audit committee financial expert.”  Sarbanes-Oxley requires that the lead audit partner and lead review partner rotate every 5 years, even if the company was private for the firs 4 ½ years.
  • Ethics: The new rules require audit firm independence.  An audit firm will not be considered independent if the company’s CEO, CFO, CAO or controller was a former employee of an audit firm that worked on the company’s audit during the past year, even if the company was private during the previous year.
  • Compensation: Sarbanes-Oxley prohibits public companies from extending credit in the form of personal loans to executive officer and directors.  However, loans made before July 30, 2002, are grandfathered.

Impact on Private Companies

The Sarbanes-Oxley Act applies to public companies.  However, private companies with exit strategies need to plan for events that would “trigger” application of this law.  The private company will become subject to Sarbanes-Oxley when it files a registration statement or when it is acquired by a public company.

Thus, in due diligence leading up to an acquisition or IPO, a private company may need to show Sarbanes-Oxley “readiness.”  If it cannot, such a failure may affect price or even imperil the deal.

Building a board of independent directors, retaining independent auditors, initiating methods to assure corporate transparency and rooting out fraud are procedures that take time to implement.  However, early adoption of these “best practices” will well position the early-stage and emerging business for exit strategies.  Just as important, these practices will make the company attractive to venture capitalists, angel investors, strategic partners and top executive talent that the company seeks to recruit.

Building a Strong Board

A strong board with independent directors is the key element to corporate governance compliance.

To guide your emerging company toward compliance with the new corporate governance rules, remember that the independent board members you seek should be independent of the CEO and management.  As a group, the board members should enhance the value of your company with comprehensive industry knowledge and a wide network of contacts.  Additionally, they should have extensive skills in management, marketing, finance and operations.  Most important though, the members you seek should have sufficient time and interest in serving and aiding the company.

In order to recruit and fully tap into the strengths and visions such a board can bring to management and to the company overall, consider the following:

  • Incentive Pay: Provide cash for meetings and special assignments that recognize the commitment involved.  Also consider deferred stock or options designed for long term support of company.
  • Meeting Preparation: Meeting packages should be prepared and distributed in advance, as well as full and timely disclosure of information.
  • Central Role & Recognition: Schedule regular board meetings with carefully kept board minutes.  Consult between meetings, keep the board well-informed of developing events and demonstrate consideration of board advice.
  • Independent Actions: There should be a meeting of independent directors and hiring of an independent chairman or board leader.

Asset of Good Governance

For some companies, the new laws arising from the recent scandals will be a costly nuisance.  Furthermore, companies simply going through the motions may find the process to still be costly and not achieve the true independence needed to unveil potential frauds.

Yet, emerging companies that embrace these new laws are able to use them as a means to strengthen the board by developing independence form management and governance procedures.  It will be discovered then that the board and the procedures that materialize from the process can themselves become assets for growth.

An emerging private company is best advised to adapt to change and make change work for the company.  Striving for a goal of ready adaptation early will produce gains in the best interests of the company.

© 2003 Robert A. Adelson


Robert A. Adelson, Esq. is a partner at Engel & Schultz LLP in Boston, Mass.

He specializes in startup and early stage corporations, trademark and trade

identification and executive employment negotiation.  He can be reached at or at (617) 951-9980 ext 205.

Covenants Not to Compete: Protecting the Legitimate Business Interest of the Employer in an Employment Relationship

Through closely scrutinized, Massachusetts courts enforce non-Compete covenants to protect legitimate interests of employer if not too burdensome on employee.

By Robert A. Adelson, Esq.

General Rule:

During employment, officers, directors and senior employees owe a fiduciary duty  to protect the interest of the company they serve.  All employees must maintain secrets material to a  business,  and no employee may steal customers or assets while still employed by a  company.  After employment ends, an employee is generally free to compete. Although post-employment competition restraints are “scrutinized  carefully”, courts in Massachusetts (as in many other states) uphold such agreements to the extent they protect legitimate interest of  the employer, do not impose an unreasonable burden on the employee, and are not injurious  to the public.  Courts may also act to limit duration or scope of agreements if unreasonable.

1.         What is an Employee Non-compete?

Non-compete in the Galaxy of Employee Restrictive Covenants

1.1       NDAs /Confidentiality

• Non-Disclosure / Non-Use

• Trade Secrets

• Proprietary Information

1.2       Assignment of Inventions

• “Work for Hire”

• Assignment of IP Rights

• Cooperation

1.3       Non-Solicitations

• Customers / Suppliers

• Prospects

• Co-workers

1.4       Employment restrictions

• Not to work for competitor

• Not to do competing work

• Defining Competing work/ companies

2.         How Restrictive is it?

Coverage and Scope of Employee Non-compete Agreements

2.1       Duration – during / after employment

2.2       Field of coverage – employer business

2.3       Field of coverage – employee activity

2.4       Geography

2.5       Exceptions

3.         Whose ox is gored here?

Stakes and Interests in Non-compete for different Parties

3.1       Employer Interest – training, access, secrets, corp. opportunities/ “good will”

3.2       Employee Interest – prior knowledge, contacts, reputation

3.3       Public Policies involved – Employee freedom vs. Employer proprietary rights

4.         When did it happen?

Effect of Timing when Non-compete arises in Employment relationship

4.1       At Hiring – employee reliance in accepting position

4.2       Mid-Term / at promotion

4.3       On Termination

5.         What kind of Work?

Effect of Type of Employment relationship

5.1       Full-time /  Part-time

5.2       Consulting / Independent Contractor

5.3       How long was employee on the job

6.         Show me the money!

Effect of Cash and Non-cash Considerations paid for Non-compete

6.1       Signing Bonus

6.2       Cash Bonus, Stock or Options

6.3       Severance Pay

6.4       Return or loss of Benefits

7.         Where’s it say that?

Documentation to effect Employment Non-competes

7.1       Employee Offer Letter/ Term Sheet

7.2       Employment Agreement;  Consulting or Service Agreement

7.3       Separate Non-disclosure /Proprietary Inventions/ Non-compete agreement

7.4       Trade secret/No conflict and other company policies – follow through

7.5       Exit Interview; severance, termination or separation agreement

7.6       No Documentation / operation of law

7.8       Severability of Terms/ Judicial Blue Pencil

7.9       Varied Enforcement by Jurisdiction

8.         Is there more than a job going on here?

Effect of Non-competes arising from Employment AND the Sale of business,

Investment in a business, and other Non-employment Motivations

8.1       Founder’s Employment

8.2       Retention Covenants

8.3       Other Hybrid Covenants


R.Adelson – 8/14/98


**  This outline was for the presentation by Attorney Robert Adelson as part of a 4-hour seminar course for attorneys, accountants and other professionals, for continuing professional education credit, sponsored by Lorman Educational Services.

Questions on this presentation or the subjects covered,  including any questions byemployees or  executives regarding non-compete, non-solicitation or other restrictive covenants or other issues of employment or employment termination, may be directed to the author and speaker at his current law firm, as follows:

Robert A. Adelson, Esq.
Engel & Schultz, LLP
265 Franklin Street, Suite 1801
Boston, MA 02110
Tel:  (617) 951-9980 ext 205

Preparing your Company for Investment – Angel and VC Term Sheet Negotiations – Post-Deal Relations

To get investment, company must put its house in order including capital, employee, IP issues. VC term sheet negotiations involve financial and control issues.

TiE SRA Leadership Workshop , June 21, 2008

By Robert A. Adelson

Business Due Diligence – Business Plan

  1. Market and customers
    • Sales Pipeline Documents
    • Customer references: validate need, willingness to pay
    • Growth and size of market
    • Sales cycle: revenue velocity
    • Distribution channel, channel partners
  2. Product and Service offering
    • Business plan, marketing literature
    • Customers – functionality; Technical Assessment & Demo
  3. Management team
    • Leadership, coachability, commitment, rolodex
    • Weaknesses or gaps in the team
    • Are they financeable by VCs?
  4. Competition
    • Customer & Alliance references and industry experts
    • Assess threats of players to company; positioning; strength focus, lead-time, financing, management team
    • Valuation – What are other deals priced at?
  5. Financials
    • Follow-on capital needs & likely sources; Milestones & valuations
    • Robustness of business model; sensitivity to driving assumptions
    • Capital structure; Previous investors
    • Realistic path to exit (time and valuation)
  6. Valuation
    • Determining the value of an asset or company
    • Size of the round? Tranches
    • Who gets diluted? Stock option pool
    • How does this fit into the overall plan of the company?

Legal Due Diligence 1 – Entity & Capital

  1. Form of entity
    • Choice of legal structure: Corporation or LLC
    • Domicile: Delaware or Local
  2. Corporate Records
    • Minute Book, Stock Ledger
    • Corporate Filing, Good Standing, Qualifications
  3. Corporate Governance
    1. Board of Directors: Size, Selection
    2. Board of Directors: Independence and Quality
    3. Board of Advisors
    4. Conflicts, Avoidance, and Disclosure of Directors’ Interests
  4. Equity structure
    • Founders’ Equity
    • Equity and Options for Employees, Contractors
    • Equity Pricing
    • Earlier Investor Equity – Preferred, Warrants, Debt
    • Shareholder Agreements
    • Securities Law compliance
    • Equity held by non-participants
    • Claims for Equity – documented / undocumented
  5. Debt Structure
    • Founder Loans
    • Friends, Family and other Loans
    • Bank Loans Collateral / Security Agreements
    • Factoring /Royalty Agreement

Legal Due Diligence 2 – IP and Other Assets

  1. Intellectual Property (IP) Rights & Protection
    • Protected Technology – Patents/Inventions
    • Protected Information – Trade Secrets – Copyrights
    • Protected Goodwill – Trademarks, Service Marks
    • Assignment of Ownership
    • Licensing Agreements
    • IP Prosecution; Vigilance against Infringement
  2. Company IP and Owner IP
    • Applications relevant to company business
    • Applications and platforms not related – Founder retention
    • Founders’ Assignment of inventions – clear demarcation
    • Investors like Focus on company
    • Founders’ Retention of post-exit IP rights
  3. Claims or potential claims against IP
    • Independent contractors – work for hire
    • Software development and distribution
    • Client & alliance contracts – IP clauses
  4. Other Assets
    • Real Estate
    • Franchises
    • Equipment, fixtures and inventory
  5. Other Liabilities
    • Claims against the assets or business
    • Litigation pending or threatened
    • State or Federal regulatory issues

Legal Due Diligence 3 – Employees & Contracts

  1. Recruitment, Retention, Incentives
    • Stock Options – ISOs and NQSOs
    • Restricted Stock
    • Phantom Stock
    • Pricing and Exercise Features
    • Employee stake in enterprise
    • Performance & loyalty incentives
    • Incentives for success events
    • Employee attrition
  2. Employee/Labor Due Diligence
    • Employment Agreements for Executives
    • NDAs, Confidentiality, Assignment of Inventions
    • Offer Letters and Hiring
    • Outsourcing/Staffing
  3. Employment Claims against company
    • History and pattern of claims, if any
    • Pending claims with MCLE or courts
  4. Commercial Contract Rights
    • Customer, Supplier Agreements
    • Warranties and warranty liability
    • Advertising or other service agreements
    • Office and Equipment Leases
  5. Strategic Contracts
    • Strategic Alliances and Partnerships
    • Strategic investment or revenue source
    • Rights of first refusal in sale of company

Negotiating the Angel / VC Term Sheet: Deal Terms – Financial

  1. Liquidation Preferences
    • Investor priority
    • Recoup principal (& often dividends)
    • “Participating Preferred” – return & upside share
    • Impact on Founders if insufficient IRR
  2. Dividends
    • Built in return – rates vary
    • Cumulate quarterly until paid out
    • No dividend on common until paid
    • Forfeiture on IPO/ voluntary conversion to common
  3. Anti-Dilution
    • If later rounds price dilutive, investor gets to re-price
    • Weighted Average – adjustment based on impact of new shares
    • Full Ratchet – if 1 share at lower price, all re-priced
  4. Participation Future Rounds / “Play or Lose”
    • Pre-emptive rights to participate, keep pro-rata share
    • Lose anti-dilution protection if not play – incentive to support
    • First offer – Go to current investors first
    • First refusal – Get to prevent new blood / Limits flexibility
  5. Redemption / “Put” Rights
    • Investor cash-out right – principal & return or appraised value
    • VC often seek redemption right within fixed time – 5-7 years, depends on stage of company, VC fund
  6. ROFR /Co-Sale on Founder Shares
    • Co-Sale – buyer must offer investors same cashout terms
    • First offer – Go to current investors first
    • First refusal – Get to scoop shares – chill offers to founders
  7. Drag-Along /Tag-Along Rights
    • Drag-Along: requires approval and sale of all stockholders on sale approval by % of preferred
    • Tag-Along: requires common to be allowed to also cash-out on preferred sale
  8. Vesting Founders Stock
    • Founders with cheap stock forced “re-earn” – vesting schedule
    • Forfeiture (repurchase at cheap price) unvested on termination
    • Effect of termination for cause or without cause, death, disability
    • Valuation of common & tax effect – income on re-earned shares
    • IRC §83(b) election – whether to take into income vesting shares
  9. Registrations Rights
    • Investor gains liquidity by “piggy-back” on to public offering
    • VCs include rights to demand registration of shares
  10. Board Composition
    • Investor representation follows the money
    • Importance of outside & independent directors
    • Management representation / “Martini” rule & board size
  11. Voting Rights/ Organic Changes
    • Investors rights to block mergers, stock issues, organic changes
    • Block rights should end if fall below fixed percent of shares
  12. Management Team/ Hiring Firing Rights
    • Pool of management shares
    • CEO and other hiring
    • Noncompete and post-termination covenants

Post-Term Sheet Documents To Complete Angel or VC Financing Deal

  1. Stock purchase Agreement
    • Preferred stock terms
    • Pricing
    • Company warranties
    • Founder shareholder warranties
    • Employment agreements
    • Post closing covenants
    • Conditions to the stock purchase
  2. Registration Rights Agreement
  3. Stock Restriction and Stockholders Agreement
    • Among founders and employee stockholders
    • Vesting terms
    • Restrictions on transfer
    • Co-sale and ROFL rights
  4. Disclosure Issues
    • State, Federal Security Laws
    • Preliminary Business Plans
    • Accredited Investors
    • Limit on Offers
  5. Disclosure Documentation
    • Private Placement Memorandum
    • Investor Questionnaires
    • Subscription Agreement and Documents
    • Audited Financials
  6. Standstill Agreement
  7. Key-person insurance & other closing conditions

Post Deal Relationship

  1. Angel Investors
    • Board seat or board observer seat – to actively advise company
    • Exploiting the Angel Group’s Network
      • Raise subsequent rounds of financing – either angel or VC
      • Recruit employees, establish customer/partner contacts
  2. Venture Capital
    • Board Seat & Help recruit key management
    • Introduce company to sources of follow-on financing
    • Guidance on financial strategy
    • Make key contacts for strategic partnerships / customers
    • Configure the company for an IPO or acquisition
    • Introduce bankers/lawyers/accountants
  3. Highlights importance of “Smart Money”
    • What besides money does investor bring to table
    • Experience of investor in helping companies like yours
    • Choosing investor value not necessarily highest valuation
  4. Operation as Angel or VC backed company
    • Collegial approach with board members
    • Importance of informed and engaged board – kept current
    • Financial statements and expected reporting
  5. Exit strategy – Implementation
    • Replacement of Founder CEO
    • Milestones to be met – consequences if not met
    • Positioning for IPO or Acquisition exit strategy
  6. Founder’s personal exit strategy
    • Role in CEO succession, post-CEO role in company
    • Protection of Founder’s equity & financial stake in company
    • Employment and Severance terms
    • Non-compete, non-solicitation
    • Retained rights and back-licenses of technology


These materials were prepared by Robert A. Adelson, Esq., Partner at Engel & Schultz, LLP, 265 Franklin Street, Suite 1801, Boston, MA 02110, (617) 951-9980. Fax (617) 951-0048. E-mail: Website: Mr. Adelson is a graduate of Boston University, Phi Beta Kappa and Northwestern University Law School in Chicago where he was a member of Law Review. He also has an LL.M. degree in Taxation from New York University and is a member of the Massachusetts, New York and US Tax Court Bars.

Robert Adelson began his legal career in 1977 as an associate at major New York City law firms, first Dewey Ballantine and later Weil Gotshal & Manges, before returning home to Massachusetts in 1985, where he has been a partner at several Boston firms before joining his present firm as senior business law partner in 2004. Mr. Adelson is specialized in corporate, taxation, finance, commercial and technology contracting law. In those areas, he frequently represents startup and smaller companies in software, and other technology-based fields. He also represents executives or consultants in executive compensation and stockholder arrangements, incorporation and liability protection, intellectual property protection, and in vendor, client and subcontractor contracting arrangements.

Mr. Adelson’s law firm, Engel & Schultz, LLP, is a small but broad service law firm of 6 attorneys in Boston. The firm complements Mr. Adelson’s work in business and tax law with seasoned attorneys in litigation, real estate, family and probate matters.

Mr. Adelson is a frequent speaker at business forums. Additional information on the subjects on which he speaks is shown at – Further information on Mr. Adelson’s background, including many of his past published articles, is available at his law firm website

The speaker thanks Hooman Hodjat, founder of iRelai, LLC for the invitation to speak,  for the TiE SRA Leadership Workshop on the topic of “Term Sheet Basics and Negotiating a deal” with my further prepared materials covering the “Fundraising Process: Due Diligence, Angel and Venture Capital Term Sheet Negotiations, Post-deal Relationships” at the 930 Winter Street, Waltham, Massachusetts, on June 21, 2008.

The purpose of these materials is to supplement class materials and offer rough outlines on the subject matter of the presentation to aid entrepreneurs seeking angel or early stage venture capital investment for early stage technology based or non-technology or service based businesses. Thus, it is hoped these materials will be informative to those in attendance. These materials are not legal advice and not intended as any substitute for professional advice or counsel in a particular case.

If Assets Need Protecting, Your Best Course May Be a Trademark

Before investing in a company or brand name, it’s wise to verify availability and file an ITU registration application to protect name and avoid infringement.

Boston Business Journal , May 2-8, 2008, page 12

By Robert A. Adelson

Your brand name can be an important asset.

As such, trademarks and service marks are recognized in common law and by statue to protect the goodwill in a brand name developed for a business, product or service.

Some brand names are just coined words – such as Kodak or Xerox – that take on great value as brand names because of millions of dollars spent in their promotion. Others can have value right from the start.

For example, say Jo Jones repairs APPLE computers.

If Jo calls the Business MacBetter Inc., instead of Jo Jones Inc., it tells about the business, suggests the nature of the business, without Jo ever meeting a customer.

That saves him money on advertising, as well as enabling potential customers to find and remember his business.

Suggestive trademarks along with associated goodwill can become valuable to consulting and service businesses as well as to businesses that market products.

Sometimes business acquisitions occur simply to obtain the rights to trademarks.

This happens where the acquirer desires to utilize the goodwill already associated in the trademark.  It also occurs where the acquirer believes a specially suggestive or memorable mark is one consumer or clients will remember and help the acquirer sell products or services.

ITU – To Preempt Your Trademark

It’s wise to first search and verify trademark availability, which is defined as nonuse by competitors.

If the name is available, consider filing an ITU, that is an Intent-To-Use application for registration with the United States Patent and Trademark Office.  For this filing, it is sufficient that you’ve thought of a brand name and intend to use it and represent that intention in your filing with the trademark office.

An Intent-To-Use registration application can hold a mark for several years before you actually market a product or service.

The ITU filing reserves exclusive rights to the mark.

Someone else might later decide to use the name and invest thousands, even millions of dollars in promotion, yet be barred from use because their new use of the trademark conflicts and thus infringes on your earlier filing.

Benefits in All 50 States

If you plan to spend much time and money to promote your product, business or service, you should conduct the search and file the ITU.

Also think about including any catchy slogan or attractive logo you plan to use.  These too can be part of your goodwill and may justify protection.

In addition, you will need to identity the products and services your mark covers or will cover.

In taking a trademark from the intent to use stage, also known as the reservation stage, to a final registration, where you have an enforceable mark, you must show use in interstate commerce – filing a specimen of use in two or more states.

Commerce in only two states or between the U.S. and a foreign state will be suffice.

The federal registration would then make the mark yours exclusively in the classes of good and services identified in all 50 states.

Prosecution Costs and Requirements

Federal trademark registration is not cheap.  Filing costs are $325 per class or per mark.

The PTO currently recognizes 46 classes of goods and services.  Filings frequently involve juggling several classes as you seek broad coverage.  Attorney fees can be $1,000 or more.

Registration is not quick or automatic.

The PTO bars registrations for “generic” or “descriptive” marks.  It also bars marks if there is a likelihood of confusion with an existing mark or for various “informalities” such as unclear wording or need to disclaim common words.

The “prosecution” process of obtaining approval can take a year or longer.  Still more filings and fee payments are required after registration.

Marks are for 10 years – and subject to renewals – but filings are needed after five years to assure the PTO that the mark is still in use.

Yet patience in prosecuting a mark is vindicated by value added to your business as a whole.

© 2008 Robert A. Adelson


The article above – “If assets need protecting, your best course may be a

Trademark” appeared in the Boston Business Journal, Issue May 2-8, 2008, page 12 of the BBJ supplement “Law & Accounting Directory”

  • If you have any questions or comments on this article
  • If you or your company would like help to protect the brand name for a business, product or service, a slogan, logo or design or packaging
  • If your trade association or non-profit group would like to file a collective mark for the group or your members or to certify goods or services
  • Or if you have other questions or issues involving trademarks or a service marks or copyrights, trade secrets or other intellectual property

The author can be reached as follows:

Robert A. Adelson, Esq.

Engel & Schultz, LLP

265 Franklin Street, Suite 1801

Boston, MA 02110

Telephone: 617-951-9980


Phantom stock gives family firms a leg up in luring key recruits

A phantom stock plan helps a family business recruit and retain non-family executives, giving them a stake in capital appreciation, liquidity and exit strategy.

Family Business Magazine , Autumn 2004, vol. 15, no. 4, pages 19-21.

By Robert A. Adelson

With the stock market apparently recovering from the “dot-bomb” crash of 2000-02, companies are again using their rising stock to lure top executive talent. If it’s time for your family business to recruit key technical employees or senior executives from outside the family, how can you compete with these non-family firms? What can you offer prospective employees instead of stock or options?

As employee appetites for stock and options rise anew, it’s important for family businesses to meet the competition by offering their own form of equity — without actually transferring ownership. The good news is that today’s tax climate has made it easier for family firms to compete in the recruitment wars.

There are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock, ways and means that are discussed in this article.

Recruiting talent from outside the family

Your business may not be able to grow or face tougher competition if there are gaps in your family members’ knowledge, skills or experience. The best way to fill in the missing pieces is by hiring non-family employees.

Even if there is no gap, it may be wise to recruit a senior manager to help train and mentor the next generation in preparation for a leadership transition — someone who would also be available to step in if illness, death or disability strikes a core family member.

Unfortunately, a family business’s stability and long-term perspective, while attractive, don’t go far enough to lure potential recruits. A non-family executive may fear that nepotism and family loyalty may supercede sound business judgment. Hopefully, if you are seeking non-family talent, your company can allay these concerns by citing its record of putting growth of the business before the personal concerns of the family owners.

Offering a stake in the upside

But even if you can show a track record of growth and sound judgment, there is something else that might make non-family candidates skittish about joining your company: the perception that as non-family members, they won’t get to share in the benefits of their hard work.

Because most family business owners want to ensure that their company stays in the family, they don’t offer their non-family employees the opportunity to own stock. But there are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock. The three strategies below — particularly the phantom stock approach — are powerful weapons in your arsenal. Recent changes in federal tax and securities laws have made these options even more attractive.

Non-voting stock and ‘rabbi trusts’

One option is to institute a non-voting stock plan for key non-family employees. Non-voting shares are allowable in LLCs, C corporations and even S corporations. This structure provides for all the capital appreciation of normal shares and permits shareholders to take advantage of the record low 15% tax rate on capital gains and dividends. Under this arrangement, non-family executives have no voice in the company’s operations and strategic choices.

The second approach is a non-qualified deferred compensation plan, which can provide a secure future payout to a key executive. Taxation to the executive is deferred via a “rabbi trust,” a trust that is set aside for the employee but remains subject to company creditors. (It was first used for a New York rabbi and the nickname stuck.) The plan can include “golden handcuffs,” or vesting arrangements in which benefits are lost if the executive leaves the company. It can also include “bad boy” provisions, in which benefits are forfeited if the executive violates confidentiality or non-compete agreements or other company rules and restrictions during employment or post-termination.

Phantom stock: The most far-reaching solution

The third approach — a phantom stock plan, taxed in the same manner as deferred compensation — combines the first two. As the most far-reaching and innovative solution, it offers the family firm a real advantage.

Under a phantom stock plan, the company sets a share value benchmark at the time phantom shares are issued (phantom strike price). The phantom stock contract issued to the executive provides a vesting and redemption schedule as well as a method of future stock valuation. If the executive does a good job and the family business prospers, when redemption occurs the executive will be paid an amount equal to the value appreciation. That is, the executive is paid the difference between the share value on the date of “sale” (phantom stock redemption or payout date) and the original phantom strike price. This spread is the same kind of payout the executive would achieve if he or she had conventional stock options in a non-family business.

A family company’s phantom plan not only offers key employees a share in the company’s growth but also can do so on far better terms than plans offered by non-family competitors. Here’s how.

Sarbanes-Oxley and phantom stock liquidity

Many small public companies are going private or delisting their securities rather than face the heavy costs of compliance with provisions of the Sarbanes-Oxley Act, passed by Congress in response to several high-profile corporate scandals.

Executives at those companies will now have equity that is illiquid. This gives closely held family businesses a distinct advantage in recruitment. A well-designed phantom plan provides liquidity (i.e., an exit strategy) for executives that small-capital companies no longer offer.

Phantom capital gains vs. incentive stock options

A phantom stock plan can generate both phantom dividends and phantom capital gains by taking advantage of the deductions available in the tax law and sharing the benefit with key hires.

Under the 2003 tax law, capital gains are taxed at 15%, the lowest rate since 1933. Dividends also are taxed at 15%, the lowest rate since the introduction of the graduated income tax in 1916.

Plans that provide incentive stock options rarely allow executives to take advantage of capital gains or dividend tax treatment. Under today’s tax law, this is a huge lost opportunity.

2004 Election:  Opportunities in new tax proposals

At this writing it is unclear whether the next administration will be Republican or Democrat, but the beneficial use of phantom stock appears likely continued and even enhanced regardless of the outcome of November 2004 election.

If the President and Congress are re-elected, the thrust of GOP tax policy in 2005-09 will be to make permanent the recent Bush tax cuts, including those for capital gains, dividends and marginal rates scheduled to sunset during that ‘05-09 period, with an added drive to eliminate all tax on dividends.  If there is a change to Democratic rule, the Kerry program would roll back those same tax cuts for families earning over $200,000 and create new tax credit incentives for high-earning employers to hire new workers.

As said a phantom stock plan that generates phantom dividends and capital gains is well positioned for these currently planned 2005-09 GOP tax initiatives. However, the well-designed plan can cope and even utilize the Democrat policy shift.  The income deferral embedded in phantom plans allows beneficiaries to spread income.  So, the Kerry $200,000 family income safe harbor is obtainable.  Also, to the extent phantom stock aids hiring it gains the family business owner a tax credit, to benefit from tax changes.

A case example

An established family business (FamCo) has outgrown its current management and wants to recruit a chief operating officer from outside the family. The top candidate knows the industry, has managed a larger workforce with multiple offices and has proved his ability to take a company to a new level.

The current family CEO, at age 70, is looking toward retirement. The prospective COO, Bill Wilson, is 55 years old. Hiring this key player would bring new vigor to the company. The parties hope to see FamCo grow from its current valuation of $5 million to $10 million over the next decade.

FamCo offers Bill Wilson phantom stock that matches his annual salary of $200,000. During each year of a five-year contract, Wilson receives phantom stock units at a strike price of $5 per unit with the units vesting annually at 20% (half the vesting based on his remaining with FamCo and half based on achievement of his performance goals). In ten years, when Wilson retires, the company would again be valued and Wilson paid on the growth of his vested units, with a buyout over ten years.

Thus, if Wilson stays with FamCo 4 1/2 years, he accumulates 160,000 units. In that time, for example, if he achieves half his business targets, he’ll vest 60% of these units (vesting 80% based on four years’ tenure and 40% based on meeting half his targets). When he leaves after 4 1/2 years, 96,000 phantom stock units are vested (equivalent to almost 1% of the company) at the original $5 per unit. Wilson has no voting rights or rights to stock, but — assuming he doesn’t violate company covenants — he will receive a future payout for the units.

Now suppose that because of Wilson’s achievements over those 4 1/2 years, FamCo grows from a $5 million company to a $15 million company by 2014. The stock price (and, thus, the phantom unit value) grows to $15 per share. Under the plan, Wilson would be paid off at the spread between the $5 original strike price and the $15 current market price in 2014. With a $10 spread per unit, the payout on Wilson’s vested units would be $960,000, which would be paid over ten years with interest on the $960,000 note at the Wall Street Journal prime rate. With phantom income spread over 10-years at $96,000 per year, this plan is well designed to be taxed at lower rates even if Kerry plans for a roll-back in tax rates occurs for families earning over $200,000 per year. Under a phantom capital gains plan, the tax deductions generated by this payout would be shared between FamCo and Wilson to reduce his tax from 35% to 15%, thus achieving effective capital gains treatment on the payout, in line with low capital gains rate achieved by the Bush administration tax cuts.

This example works for any family business in any American industry, whether the business valuation is $5 million or $5 billion. Although the company must incur the cost of paying out phantom stock, it derives a much greater benefit from growth. These plans give family-owned companies the ability to recruit and retain key talent, which more than offsets the cost involved.

Robert A. Adelson, J.D., LL.M, a partner in the law firm of Engel & Schultz LLP in Boston, is a corporate and tax who represents closely held and family businesses and executive employees.

© 2004 Robert A. Adelson


Robert A. Adelson, Esq. can be reached at Engel & Schultz LLP,

265 Franklin Street, Boston MA 02110

(617) 951-9980 ext. 205