Drafting Contracts

23 March

• There are SEC rules about how financial statements need to be reported. It can help to understand what the regulations are talking about. A lot of representations and warranties in purchase agreements have to do with warranting that financial statements are in order (e.g., seller has no liabilities of any kind except for those reported on the balance sheet).
• Financial matters can be a headache for lawyers: contingent purchase prices (a portion of the price to be determined post closing). "Earn-out" provisions can be tricky (esp. the definition of "earnings:" these can depend on the operation of the company by the new owner, or changes in accounting practices).
• If you're borrowing money, there will be endless covenants about the ratios between borrowings and shareholder assets and so forth. So you'll be working with accountants, no doubt.
• Handout #1: Merrill Lynch: How to Read a Financial Report. Usually includes: balance sheet, income statement, and a statement of cash flows.
• Handout #0: Pique/Peak/Peek.
• Privately held companies aren't necessarily required to have audited financial statements, but lenders may require it (or they might do it for their own reasons). The big 4:
  1. PWC
  2. E&Y
  3. Deloitte & Touche
  4. KPMG
• FASB (Financial Accounting Standards Board): defines GAAP.
• The starting point for most accounting is historical: the cost of an asset is usually the value ascribed to it on the company's books. That gets depreciated, but fluctuations in market values are generally not taken into account. This is a GAAP principle: it's supposed to be conservative (i.e., no "writing up" the value of assets). Companies can choose how agressive they're going to be within GAAP: there's judgment and flexibility, and companies can disagree with their auditors.
• Balance sheets are the most easy: see p. 4 in the Merril Lynch report. Assets = liabilities + shareholder equity. The balance sheet is a snapshot as of a particular point in time. So, shareholder equity = assets - liabilities. It's just what you'd get if you wound up the business and sold all the assets. Note that this has nothing to do with market capitalization, which has no effect on the company's balance sheet. Market capitalization reflects trades among shareholders, not the business itself.
• "Book value per share of common stock" is the value of the company based on the balance sheet, divided by the number of outstanding shares. But of course there can be different classes of shares. And book value can be a somewhat misleading statistic; it's more meaningful for insurance companies, banks, investment companies (because their assets tend to be liquid, so book and market value are similar).
• Liabilities on a balance sheet don't usually don't include contingent liabilities. This is why you read the notes to the financial statement, not just the balance sheet.
• The income statement is a moving picture: it matches the revenue received from business with the costs incurred in doing business. This tells you the net income for the year: revenues - expenses = net income. Accounting for inventory is important on income statements: LIFO, FIFO, and average cost method (deprecated, not used much any more). Basically do we figure our our costs of sale against our newest or oldest inventory? Selling the newest goods first, in an atmosphere of increasing costs (i.e., in an inflationary economy), is more conservative: it will depress the level of reported income, and thereby lower taxes. It also allows you to show un-sold inventory at its older (and therefore lower) cost, and this too is conservative. FIFO is more representative of how most companies actually do business (i.e., trying to move older inventory): it results in higher income and higher inventory valuations. This choice is important because it bears directly on gross profit (by altering the cost of goods sold).
• When a company switches from LIFO to FIFO (or vice-versa), it's a big deal, and it requires a lot of explaining to shareholders about how various reports are not comparable.
• Assignment: Sligo Inc. v. Trustees. There are two shareholders, and they each own half of the outstanding stock in Sligo. Back when they formed the company, they entered into a restrictive stock transfer agreement, which gave the corporation a right of first refusal, and contained obligations upon the death of a shareholder.

  There's a fallback provision in the agreement about how to deal with the death of a shareholder in the event that there was no current valuation.

  Problems:

  • Book value is a snapshot. "For the period ending" is ambiguous. Does it mean "as of," or is there some significant period that we're supposed to be aware of?
  • What is "said" book value?
  • Is this supposed to reflect whether the death happens before 12/31/89 or after?
  Trial court thought one thing, Ct. App. reversed, and there was a dissent.
• Our mission: re-draft that section so that it unambiguously supports each of the parties.
• Due 5:00PM Friday.