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Entities for Businesses with Social Missions

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If your business has a socially beneficial mission but wishes to operate with a for-profit model, then you may be interested in forming a hybrid entity.

Low Profit Limited Liability Company (L3C)

 An L3C functions like an LLC with a socially beneficial business purpose. While L3Cs operate like LLCs, they benefit from a tiered capital structure that permits the L3C to raise capital through both the Program Related Investments (PRIs) of private foundations as well as commercial investments.

Advantages:

                Like an LLC, an L3C benefits from flexible ownership structure and pass-through taxation.  Unlike an LLC, an L3C may implement a tiered capital structure through which private foundations effectively subsidize commercial investments.  The lowest tranche of this tiered L3C capital structure is allocated the highest risk and the lowest rate of return.  This tranche is reserved for PRIs made by private foundations.  PRIs allow foundations to contribute to for-profit businesses without incurring negative tax-penalties.  To qualify as a PRI, the use of a foundation’s investment must correspond with the foundation’s charitable purpose and the funds are prohibited from inuring as a benefit to other private parties.  The restriction on private inurement means that a foundation’s investment cannot be used to make excessive distributions to L3C insiders or its other investors.  The mezzanine tranche is reserved for socially responsible investors who may be willing to take on below-market returns because of their commitment to the L3C’s social or charitable goals.  Finally, private commercial investors are relegated to the upper tier where returns are highest and risk is lowest.  Through this tiered capital structure, an L3C may be able to attract both profit-driven and charity-driven investors.

Moreover, while many commercial investors are hesitant to invest in social businesses, investors and customers who share similar convictions may be drawn to the commitment to a particular cause evidenced by the choice of the L3C entity.

 

Requirements/Disadvantages:

 

First, only Vermont, Michigan, Wyoming, Utah, Illinois, Louisiana, Maine and Rhode Island have L3C statutes, limiting L3Cs to those states.  Second, L3Cs must be organized in accordance with three principles: 1.) an L3C must be organized around the primary goal of achieving a charitable, educational or socially-beneficial purpose, 2) the production of income or appreciation of property may not be a significant purpose of the L3C, and 3) an L3C may not seek to accomplish any political or legislative purpose.

Attracting PRIs may pose particular difficulty and risk.  In order for a private foundation’s investment to qualify as a PRI, the L3C must further the foundation’s charitable goals.  If the IRS rules that an investment in an L3C jeopardizes the tax-exempt purpose of a particular private foundation, then that foundation will be subject to an automatic 10% excise tax and the potential for additional penalty taxes.  Further still, even if a private foundation’s investment qualifies as a PRI, if any part of the foundation’s investment inures to a private individual, such as a commercial investor in the L3C, the private foundation may lose its tax-exempt status.  To mitigate these risks, private foundations will typically negotiate for management rights.

Furthermore, the L3C structure is risky because it is extremely new. The IRS has not designated private foundation investments in L3Cs as automatically qualifying as PRIs, nor have they articulated that such investments are entitled to a rebuttable presumption of PRI qualification.

Finally, the L3C is risky because it is built on the competing interests of profit and social benefits. It remains to be seen how courts will interpret that combined mandate.  How venture capitalists and angel investors will treat L3Cs in the long-term remains equally unclear.

Benefit Corporation

The Benefit Corporation is a status available in 30 U.S. states.  That status accords legal protection to corporate directors and officers who wish to balance financial and social interests when making corporate decisions.

Advantages:

The primary advantage of a Benefit Corporation is that its officers and directors may simultaneously seek to maximize profit and social impact. Unlike the standard corporate form where directors and officers have a duty to its shareholders to maximize profit, directors and officers of a Benefit Corporation have the freedom to balance the Corporation’s profit motive with the achievement of its social mission.  This Benefit Corporation structure thus permits socially minded entrepreneurs to protect their social mission as a critical part of their business.  Furthermore, stockholders have the increased power to hold directors and officers accountable in their duty to pursue that social mission.  The Benefit Corporation’s accountability structure thus may be attractive to socially conscious investors who want to ensure that their investment is impactful.

Requirements/Disadvantages

A Benefit Corporation must hold a public benefit as part of its stated mission and assign a benefit director to oversee the progress towards achieving that mission.  Benefit Corporations are subject to heightened reporting requirements, namely the requirement to release a benefit report to the public (in Delaware the report need not be public).  The benefit report is meant to facilitate transparency so as to inform the public of the corporation’s social performance, inform directors so they are better able meet their duties in pursuit of the public mission, and inform shareholders of the Corporation’s progress towards its social mission so that they might exercise their rights to hold the directors and officers accountable.

Finally, like the L3C, Benefit Corporations are fairly new and how courts will interpret the combined mandate of seeking profit and social benefits remains unclear.  Likewise, how venture capitalists and angel investors will treat Benefit Corporations in the long-term is equally uncertain.

B Corp.

 

A B Corp is a for-profit company that has been certified by the nonprofit organization, B Lab, to meet rigorous standards of social and environmental performance, accountability, and transparency. Such designation is meant to signal customers, investors, and other corporations that the entity satisfies certain desirable benchmarks of corporate responsibility.

All entity types are eligible to apply for B Corp status. In applying, entities must subject themselves to a rigorous assessment and review of their goals and practices.  In addition, 10% of B Corps are subjected to random on-site review each year.  Each B Corp is required to resubmit the majority of its assessment every two years for reevaluation.

The easiest road to B Corp status is to first become a Benefit Corporation. In states where Benefit Corporations are not available, or if your entity is an LLC, C Corp, S Corp, or Partnership, you may amend your articles of incorporation or organization to permit officers or members to weigh the environmental and social effects of the company’s operations alongside the interest of the shareholders.  Introducing a social or charitable mission into your business purpose is the best way to shape your entity and its practices to qualify for B Corp status before applying.

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Alternative Dispute Resolution in Terms of Service

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As web-based startups grow, they naturally begin to attract users across state lines and international borders. For founders who have worked hard to get this traction, this is rightfully considered cause for celebration, but it is important to consider that this expansion comes with a bit of additional risk. With larger and more widely distributed user bases, startups are exponentially more likely to see an increase in the frequency and complexity of disputes involving its users. While these disputes are to some degree inevitable, a startup can still safeguard its interests by crafting a clear dispute resolution policy in its terms of service.

There are a range of different ways that a dispute resolution policy can be crafted in a company’s Terms of Service, but the startup’s choice essentially boils down to two means of conclusively settling disputes- litigation and arbitration. As described below, the latter presents significant advantages to early-stage companies.

Litigation: If a startup chooses to use litigation as its preferred means for final dispute resolution, its Terms of Service will generally indicate that a particular state’s laws govern (i.e. Delaware or the state where the company is located). This does not, however, ensure that the dispute will be heard in a court in that particular state. Under certain circumstances, users-turned-litigants may be able to have their suits against the company heard in a federal court (referred to as “removal”) that will apply the designated state’s laws, even though the federal court may not be located within that state. Hence, while this method provides a startup with some certainty as to applicable law, there remain a number of drawbacks to a dispute resolution policy crafted in this fashion which include:

Forum: A litigation-based dispute resolution policy doesn’t necessarily provide for certainty as to forum given the possibility of removal to federal courts. Should removal occur, the startup will still have the “home field advantage” in terms of governing law, but, depending on the federal court selected by the user, it might lose the convenience of settling its dispute close to company headquarters. Instead, founders may be forced to travel to a federal court across the country to settle disputes with users. For founders short on time and money, this may pose a tremendous obstacle to mounting a defense.

Expense: It is also important to remember that this type of policy will require founders to incur great expense in the event of a dispute. Litigation involves significant costs in the form of court filing fees and attorneys’ fees, and even if the startup is successful in defending itself in court, it is highly unlikely that the company will be able to recover these expenses. In the event of removal to federal court, the startup may also face significant (and unrecoverable) travel costs. For early-stage companies trying to carefully manage limited funds, these enormous expenses may be prohibitive and the company may be forced to settle disputes on highly unfavorable terms.

Time: Another downside to litigation is that it can be an incredibly drawn-out process. Between initial motions, discovery, and the actual hearing (assuming no settlement is reached), the process can take years. When appeals are taken into account, disputes can continue on seemingly without end.

Public Relations: Beyond the substantive hurdles associated with litigating disputes, there is also the problem of public perception. Lawsuits, particularly suits where users are making incendiary allegations, can turn off users and destroy a company’s momentum. In a similar vein, pending litigation may also turn off investors who may not be willing to associate themselves with a company that has experienced a loss of reputation in the public eye. This sort of damage is incredibly difficult to recover from, even if the company ultimately prevails in handling its dispute.

Arbitration: While some of the issues associated with litigation are unavoidable (disputes with users will always entail a loss of time and money), arbitration presents an alternative that can in many ways mitigate these downsides.

Forum Certainty: An arbitration policy typically identifies not only the particular arbitration company that will be administering the arbitration, but also the location where disputes will be settled.

Reduced Cost: While there is no clear consensus as to whether or not arbitration is cheaper than litigation, there are reasons to think that arbitration can cut costs. While both litigation and arbitration require the use of an attorney, arbitration offers more flexible procedures than courts, so there may be reduced costs associated with motions and discovery. Additionally, where the parties have agreed to “final and binding” arbitration, the costs associated with the appeals process are eliminated.

Increased Efficiency: In addition to being cheaper, arbitration also generally provides for a quicker resolution of disputes than litigation. Additionally, arbitration policies can be crafted to eliminate appeals, further shortening the dispute resolution process.

Confidentiality: While filings and court orders in litigation automatically become part of the public record, arbitration allows for much of the dispute resolution process to occur outside of the public eye. One reason for this is that arbitration companies are private entities and are thus not subject to the same disclosure requirements as their government counterparts. Another is that arbitration provisions may explicitly require parties to agree that dispute resolution in arbitration will be confidential. The consequence of this heightened confidentiality is that the dispute resolution process has much less of a prejudicial effect on the company’s reputation and, by extension, its prospects of obtaining venture financing.

In light of these points, a dispute resolution policy centered around arbitration should be given strong consideration by most early-stage ventures. However, even if an arbitration provision proves to be the appropriate choice for a particular startup, its founders would be wise to consult an experienced startup attorney to handle its drafting, as they are complex provisions and, in light of the Supreme Court’s 2011 decision in AT&T Mobility v. Concepcion, they need to be drafted very carefully to ensure that they are fair and enforceable.

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Revisiting Regulation A+: A Few Considerations

Entrepreneurs should consider the risks and rewards of a Reg A+ offering. Image by Andrew Magil on Flicker. CC By 2.0 License.

Entrepreneurs should consider the risks and rewards of a Reg A+ offering. Image by Andrew Magil on Flickr. CC By 2.0 License.

The ability to successfully fundraise is typically a significant factor in an early technology venture’s success. While most seek to raise capital from a small number of wealthy individuals or institutions, such as angel investors or venture capital firms, entrepreneurs are increasingly seeking the ability to raise capital through larger groups of investors, each offering a smaller financial contribution. Until recently, startup financings have typically fallen under Regulation D, a set of three rules – 504, 505, and 506 – which carve out exemptions to the registration requirements of the Securities Act of 1933, as described in this prior post. However, “Reg D offerings” are not without limitations – offerings conducted under Rule 504 are capped at a modest $1M, while offerings under 505 and 506 significantly limit the number of unaccredited investors. Although still a popular option, Reg D offerings often do not give capital-starved ventures the ability to sell to a much larger pool of interested investors, especially one including unaccredited investors..

It is not surprising then that there was significant excitement within the entrepreneurial community when the SEC finalized amendments to Regulation A in June 2015. Similar to Regulation D, the existing Regulation A provided an alternative set of exemptions to the Security Act of 1933, but these exemptions did not include limitations on the number of unaccredited investors. However, prior to this recent amendment, due to the fact that Reg A offerings were capped to $5M per sale and subject to burdensome “blue sky” security laws of individual states where securities would be sold, Reg A offerings have failed to take off. The new amendments to Regulation A, dubbed “Regulation A+,” created buzz by raising the dollar limit from $5M to $20M and $50M for each of the respective Tier 1 and Tier 2 offerings. Combined with a new coordinated review process for Tier 1 offerings and blue sky law exemptions for Tier 2 offerings, Regulation A+ gives entrepreneurs the ability to raise much more per sale while bypassing the time and financial costs associated with blue sky law compliance.

Since June 2015, the SEC has received many filings and have qualified around a dozen sales to date. A few examples of recently qualified offerings include:

  • Sun Dental Holdings, LLC – A traditional dental device manufacturing company that also focuses on digital scanning, cloud-based data management system and 3D printing to produce dental devices.
    • Sun Dental filed and qualified a Tier 2 offering for $20 million (9/3/15 – 12/1/15).
    • Disclosed costs include $330K in legal fees, $380K in audit fees, and $950K in underwriting fees.
  • Groundfloor Finance Inc – An online investment platform designed to source financing for real estate development projects.
    • Groundfloor has had two Tier 1 offerings qualified, the first for $545K (3/23/15 – 8/31/15) and the most recent for $1.5M (10/7/15 – 10/29/15).
    • Disclosed costs for the first offering included $458K in legal fees, $30K in audit fees.
  • Elio Motors – An automobile company planning on manufacturing low-price, compact cars for a fraction of the price.
    • Elio filed and qualified a Tier 2 offering for $25M (8/28/15 – 11/20/15).
    • Disclosed costs include $110K in legal fees, $25K in audit fees.

While Reg A+ offerings have been gaining some traction, there are still significant obstacles in pursuing this financing option. Some issues entrepreneurs should consider before proceeding include:

  1. Cost. The first obstacle to Reg A+ has been the fees associated with completing and filing the application. While not as costly as an actual IPO, Regulation A+ still requires a dedicated team of lawyers and accountants to produce the offering circular and the financial statements (audited, if conducting the more lucrative Tier 2 offering). Recent filings have put legal fees anywhere from the low thousands up to $485K, and auditing fees typically add on another $20K to $30K. Due to the complexity of securities law and filing requirements, experienced counsel and the associated fees are essential to the process.
  2. Administrative Burden. In addition, the venture must be prepared to handle the administrative aspect of filing and selling securities under Regulation A+. Developing the substance of the offering circular will be time consuming, and companies conducting a Tier 2 offering will be on the hook for ongoing reporting requirements. For a leanly staffed team, the administrative burden might be a significant worry.
  3. Liability. Sellers of Regulation A+ securities are liable for any material misleading statement or omission made in an offering circular or oral communications, and anything said in the offering circular could be used in litigation down the road. As such, entrepreneurs must be careful to engage with experienced counsel in developing their circular.
  4. Impact on Future Investors. Experienced attorneys have brought up concerns surrounding the impact of introducing many unaccredited investors into a company’s cap table. There appears to be a consensus that VCs and other institutional investors tend to shy away from companies that have “crowded cap tables” because it can be difficult and risky to invest in a early-stage company with such a composition.
  5. Public Disclosure. Entrepreneurs will need to provide significant disclosures about their business and financials in its offering circular. This can sometimes be an issue for a venture that prefers to keep certain facts about its technology or financials internal until a more appropriate time.

While brimming with potential, Regulation A+ offerings can hardly be considered “easy money.” These very real obstacles are substantial, and should give any prudent entrepreneur pause to entertain other, more traditional financing methods. Those who do decide that they have the appetite to pursue a Regulation A+ offering should do so with ample resources, experience counsel, and a clear understanding of the difficulties involved in the process.

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Possibilities for Blockchain and the Legal Implications

FrankieRufinBlogPicBlockchain technology is a new way of establishing trust in the presence of unreliable parties. Although it owes its current celebrity to Bitcoin, the cryptographic power of blockchain can be harnessed in a variety of different ways, making it capable of revolutionizing a lot more than just how we do business. Along with these new possibilities, however, new complex legal issues are expected to arise.

What is blockchain technology?

Blockchain is best known as the underlying technology that makes Bitcoin possible. Bitcoin’s system of transactions is decentralized, meaning that no central authority tracks, approves, or secures transactions made on the Bitcoin network. Instead, Bitcoin relies on blockchain technology—rooted in cryptography—to achieve a secure and usable system.

For those new to blockchain technology, it is essentially a decentralized public ledger of transactions that works as follows:

  • When a user initiates a new transaction, the transaction is grouped with others into “blocks” and consistently added to the ledger.
  • The blocks are then redundantly verified by the distributed computing power of the users connected to the network and added to the “block chain.”
  • A unique cryptographic “hash” identifies all blocks and transactions and permanently fixes them in chronological order, making it virtually impossible to modify past transactions in the chain.

The result is “trustless” system of transferring assets with no need for a central processor. Every payment is recorded and verifiable by anyone who accesses the public blockchain.

Blockchain is the next big thing.

Blockchain technology is not limited to transfers of virtual currencies. It has far-reaching potential in a wide variety of industries and applications. In brief, blockchain technology makes it possible for a community to manage something that previously required a centralized authority.

A growing number of organizations are beginning to use blockchain technology to build infrastructure to support decentralized peer-to-peer applications, while others are attempting to create decentralized versions of existing internet applications. From regulatory reporting to derivatives settlement, blockchain technology can be utilized to revolutionize many key service industry sectors, yielding increased consumer power, greater personal data ownership, and reduced transaction costs over the long term.

Legal Implications.

Thus far, regulators and enforcement agencies have focused on the legal issues surrounding the use of virtual currencies in financial transactions. However, the legal landscape gets markedly more complicated when discussing the broad applications of blockchain technology.

As outlined in a recent Bloomberg BNA Banking Report, anticipated legal issues include—but are not limited to—the following:

  • Utilizing blockchain in the context of intellectual property would necessitate a doctrinal and legislative shift, as current IP licensing law is based on contractual relationships between parties, not on transferable property rights that could be sold later on.
  • In the storage of identity information, legal implications could include privacy concerns and whether a right to privacy would even exist in such applications.
  • The use of smart contracts raises several legal concerns. For instance, the automatically enforcing nature of smart contracts would make it difficult to apply some classic contract doctrines (ex. voiding a contract due to coercion), and the contracts may be programmed to be impossible to breach, even efficiently. In addition, these interactions would carry privacy concerns, as contracts between parties would be publicly viewable in the ledger.
  • Advanced applications of smart contracts would allow for the existence of decentralized organizations, raising issues of liability and ultimate responsibility. Legal systems would have to determine who to hold responsible if laws are broken, as “management” is conducted automatically. Further, it is possible that existing legal frameworks relating to corporations and other business entities are insufficient, and that new regulations would need to be developed.
  • Blockchain can accomplish escrow services utilizing “multi-signature transactions” although the arbiter in the transaction does not actually take possession of the virtual asset.  Because existing legal frameworks are designed to regulate escrow agents who assume full control of an asset, they may prove to be incompatible.
  • Attempts to offer securities and financial products are likely to increasingly implicate securities laws.

We have already seen virtual currency ‘rock the boat’ and swiftly prompt significant legal and regulatory change. With the potential applications of blockchain technology—capable of completely revolutionizing the way we interact and exchange information and value—we can reasonably expect momentous changes to our legal framework.

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Keeping Public Disclosure Risks in Perspective

Publicly disclosing a patentable invention prior to filing your patent application has its risks, but startups need to keep these risks in perspective.

Publicly disclosing a patentable invention prior to filing your patent application has its risks, but startups need to keep these risks in perspective.

Start-ups must at once protect their valuable intellectual property and promote their product to customers and investors. These two functions—protection and promotion—are often in conflict, especially for a start-up in its early stages. At large, publically traded corporations, intellectual property protection is usually automatic. While large corporations generally have several bureaucratic levels of decision-making related to patent protection, they also have the resources to promptly file patent applications when necessary. Many start-ups have neither the institutional knowledge nor the capital to file a patent so quickly.

But more often than not, start-ups also do not have the luxury of suspending business activities until they have enough capital to seek intellectual property protection on their products. In today’s booming tech economy, delaying critical business even a few weeks might position a start-up perilously behind its competitors. So start-ups are forced to disclose their products and technology to potential customers and investors without the critical safety net of a filed patent application. A start-up may have to disclose certain aspects of its technology at pitch competitions or to venture capitalists, and it certainly must test iterations of its product with small groups of consumers prior to a larger product launch. Each of these activities may constitute a “public disclosure” under 35 U.S.C. § 102 and affect the future patent rights of both the start-up and other parties. And even apart from the legal consequences, start-ups may have an incentive to keep their secret to success hidden from the prying eyes of potential competitors.

What is a public disclosure?

A public disclosure is any (1) non-confidential communication, (2) which an inventor makes to one or more members of the public revealing the existence of his invention, and (3) enabling a person having ordinary skill in the art to reproduce the invention.

(1) Non-confidential: generally, a communication is non-confidential if it does not require secrecy by the person receiving the communication. If the person receiving the communication has, for example, signed a non-disclosure agreement (NDA) covering the subject matter of the invention, then that communication is likely confidential and would not be considered a public disclosure.

(2) To the public: a communication need not be made to a large group of people to be “public.” A communication about your invention to a single person, without the expectation of secrecy, could be considered public.

(3) Enabling: a communication regarding one’s invention is “enabling” if it is detailed enough to allow someone with expertise in the subject matter to create the invention. For example, a communication listing the components in an invention and describing how those components are put together would likely be enabling. In contrast, simply naming one’s invention would likely not constitute enablement.

Examples of public disclosures include articles in scientific journals about the invention; abstracts, posters, and presentations; and even the public use or sale of the invention.

What are the consequences of a public disclosure?

Publically disclosing an invention has a number of business and legal consequences. First, after making a public disclosure, an inventor has a one year “grace period” during which to file a U.S. patent application. After that grace period has expired, the inventor can no longer obtain a patent on the disclosed invention. Fortunately, third-parties do not have this same grace period. Once an inventor publically discloses his invention, that disclosure serves as prior art against all other parties seeking to patent the same invention.

What, then, is the risk of publically disclosing an invention? On its face, a public disclosure seems like a win-win scenario—the inventor is allowed a grace period to file a patent on his invention, and all other parties are hypothetically barred from obtaining one. That thinking isn’t totally incorrect. Publically disclosing an invention does provide an inventor some protection. But consider these scenarios:

(1) A third-party uses an inventors’ disclosure to create a similar but not identical invention that does not infringe but performs substantially the same function.

(2) The inventors’ disclosure is not specific enough to meet the enablement requirement but nonetheless incites a third-party to innovate in the same area and enter the market.

In both of these circumstances, the inventor has given potentially valuable information to a competitor who could beat the inventor to market. But in the context of an early stage start-up, sometimes it is necessary to take this risk. For example, when a venture capital (VC) firm is vetting a start-up in preparation for a potential round of financing, it will certainly want to learn as much as possible about the technology or product that forms the foundation of the start-ups’ business. This may require a non-confidential disclosure to the VC firm, especially since VC firms tend to be averse to signing NDAs. If the start-up wants to secure financing, this disclosure is necessary and usually an acceptable business risk. Similarly, most start-ups will at some point in time need to test their product with a group of consumers before taking the product to market. This testing likely constitutes a public disclosure, and it may be cumbersome to have each and every consumer who tests the product sign an NDA. Again, this may be a tolerable business risk for a start-up.

How can a start-up mitigate the risks of a public disclosure?

There are several steps that a start-up can take to mitigate the risks of a public disclosure:

  • File a provisional patent application prior to the disclosure. Provisional patent applications are substantially cheaper than standard utility patent applications and can be prepared by the inventor or an attorney. A non-provisional application must be filed within 12 months of the provisional application, or the provisional application is abandoned.
  • If practical, ask the receiving party to agree to an NDA.
  • If a public disclosure is a necessary business risk and a patent application has not yet been filed, make sure the disclosure is as broad and non-specific as possible. A broad disclosure will likely not enable another party to copy your invention. In many cases, the specifics of the technology do not need to be disclosed. One can rather talk about the problem, the market opportunity, and other aspects of the business.

Generally, taking these steps will be sufficient to protect a start-ups’ patent rights in the U.S. While filing a patent application offers the best protection, disclosures without one are sometimes a necessary business risk. But the content of a disclosure can be limited in a way that does not affect the patent rights of the start-up and will not allow potential competitors to benefit from it. Even in cases where a competitor is able to glean some useful information from a disclosure, the start-up likely has a major head start in getting to market with a viable product.

Moreover, even if a startup loses foreign rights in a patent, a U.S. patent is often a good starting point, allowing the start-up to later pursue international patent protection on new creations and improvements.

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Re-allocating Equity in Your Startup

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

We have previously written about considerations for founders in splitting initial equity in their startup.  No matter how thoughtful founders are in dividing their initial equity, it is common for founders to realize after a period of time operating their company that their initial equity allowances do not accurately reflect the actual contributions or value from each team member.  Founders often believe they can simply create their own document redefining their split of equity %’s.  In the case of an LLC, founders often try to simply amend the cap table exhibit to their Operating Agreement.  While these steps are better than nothing, reallocating equity %’s involves transferring shares (for a corporation) or units (for an LLC) and therefore could trigger some tax and securities issues.  Additionally, it is important to generate clear documents, signed by all involved parties, in order to avoid later disputes over the number of shares/units held by individuals (especially when those shares/units hold more value).   Just as importantly, maintaining a clean and clear cap table is really important for early stage startups.  Investors will typically want to see clear documents showing the issuance from the company to each shareholder of shares that correlate to the numbers of shares indicated on the cap table.   This post provides a few specific methods for properly reallocating equity in an early-stage startup.  The specific approach will spend on the specific governance documents and circumstances for your startup, so please consult your attorney.  This post assumes a few important things:

  • the company is pre-financing and it can issue equity at a nominal valuation (in the case of a corporation, at or near par value of $.0001 or $.00001).
  • all stockholders are remaining involved with the company, in other words, no one is terminating an employment or contractor arrangement with the company.
  • the company’s board of directors (for a corporation) or board of managers (for a manager-managed LLC) are remaining the same.
  • the company has implemented standard vesting procedures for all founders (to learn more about vesting, see this primer on vesting.)

Calculating the Adjustment

The first step in reallocating equity is to figure out how much stock (for corporations) or units (for LLC’s).  Presumably, you have determined your new desired %’s.  You might think about your desired outcome in terms of %’s, but in order to get there, you need to think about the number of shares or units held by each individual.  For example, assume three individuals (Founders A, B, and C) currently own respectively 40%, 40%, 20% of the issued equity in a company, reflected by having been issued 2M, 2M, and 1M shares respectively.  They’ve decided to reallocate equity so that the three founders will own 30%, 30%, 40% of the issued equity respectively.

There are a variety of ways to achieve this outcome.

1) Issuing More Shares/Units to the Founders Desiring to Increase Their %.

For example, the company could simply issue Founder C more shares so that Founder C holds 40% of the new total.  In the above example, this would mean issuing Founder C 1,666,667 shares so that Founder A and B would still each own 2,000,000 shares and Founder C would own 2,666,667 shares and the equity would be divided 30%, 30%, 40% respectively.

When issuing more shares to Founder C, if the startup is a corporation, it would ensure it does not exceed the number of authorized shares in its Certificate of Incorporation.

The following documents would typically be used to execute the above:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,666,667 shares/units to Founder C.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,666,667 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.

2)Repurchasing Unvested Shares/Units from Founders Desiring to Decrease Their %.

Another way to reallocate equity using the above example, is to repurchase unvested shares from Founders A and B.  Using the above example, the Company could repurchase 1.25M shares/units from each of Founders A and B, so that they would each own 750,000 shares/units and Founder C would still own 1,000,000, providing the desired 30/30/40 split.  Note that repurchased shares go into the Company’s treasury (ie., as authorized but unissued shares).  They effectively disappear into the ether, which allows Founder C’s % to increase even though she maintains the same number of shares/units.

The following documents would be used to execute the above:

  • A Board consent (signed by all directors in the case of a corporation or managers in the case of an LLC) authorizing the company to repurchase 1.25M shares/units from each of Founder A and B.
  • Repurchase Agreements between the Company and each of Founders A and B.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

3) Combination of #1 and #2 Above.

Another way to reallocate equity in the above example would be to repurchase 500,000 shares/units from each of Founders and and B and issue 1,000,000 new shares/units to Founder C.  This would keep the number of issued shares/units constant at 5,000,000.  This method might be preferable if the startup didn’t have enough authorized but unissued shares/units to issue Founder C without repurchasing some from Founders A and B (making method #1 impractical because it would require amending the Certificate of Incorporation for a corporation), Founders A and B didn’t have enough unvested equity to repurchase the necessary shares/units (making method #2 above impractical), or the startup otherwise wanted to maintain the existing number of issued shares/units.

To implement this approach, the Company would use the following documents:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,000,000 shares/units to Founder C and the company to repurchase 1.25M shares/units from each of Founder A and B.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,000,000 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • Repurchase Agreements between the Company and each of Founders A and B where the Company repurchases from Founders A and B 500,000 shares/units each.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

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Changing the Registered Office of a Michigan LLC

Some economic development organizations may require your company to have a registered office in a certain vicinity.

Some economic development organizations may require your company to have a registered office in a certain vicinity.

Michigan has several economic development organizations that require startups to maintain an office in a certain city or vicinity in order to receive funding from that organization.  Some of these organizations will merely require that the startup maintain an office or a principal place of business in a certain location.  Others, however, will require that the startup’s “registered office” be in that vicinity.  This post: (1) explains what is a “registered office;” and (2) describes how to amend the location of your registered office for a Michigan LLC.

What is a Registered Office?

The Michigan Limited Liability Act (Section 207) requires Michigan LLC’s to maintain a “registered office.”  Simply put, this is the address where the state can send your company important information and assume your company received it.  The registered office is identified in Article IV of the company’s Articles of Organization, which are publicly available and filed with the state of Michigan.

Article IV Articles

We have previously discussed the Articles of Organization here.

It is important to note that the registered office does not need to be the same as the company’s principal place of business.  In fact, because many early-stage startups operate from work sharing spaces, incubators, or accelerators, the company’s principal place of business will, in fact, differ from the registered office (which will ideally be a more permanent address where the company is more certain to receive important state documents).  Many student entrepreneurs will use a parent’s permanent address (in Michigan) for the Michigan registered office.  Accordingly, before taking the time to change your registered office in your Articles of Organization, confirm that the funding organization does indeed require the registered office (as compared to a principal place of business) to be in a certain vicinity.

Amending Your Registered Office

If you determine that you need to change the registered office identified in your Articles of Organization, here is how to proceed.  The fee is $5, although expedited service is available for the higher fees described on page 3 of the Certificate of Registered Office (Form 520).

  1. Locate your ELF account number.  Or, if you have not set up an ELF account with the state of Michigan, do so.  This post discusses the benefits, and process of establishing, an ELF account.
  2. Complete the Certificate of Change of Registered Office (Form 520).
  3. Complete your MICH-ELF COVER SHEET, which will be filed along with the Certificate of Change of Registered Office (Form 520) that you completed in Step 2.
  4. Following the instructions which you received in the Response to your ELF Application, file the documents you completed in Steps 2 and 3 above.  As of the date of this post, ELF account filers may electronically file via email at cdfilings@michigan.gov.
  5. Filers without an ELF account may submit the above forms along with a check or money order to:

Michigan Filing Address

Once you have changed your registered office, understand that this is where the state will send important information, such as your annual statements.  If you change locations, and your registered office is no longer a valid mailing address for your company, you will need to use the above process to change the registered office identified on your Articles of Organization.

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Convertible Equity – A New Hope?

YCombinator's SAFE documents are a popular mechanism for implementing a convertible equity financing arrangement.

YCombinator’s SAFE documents are a popular mechanism for implementing a convertible equity financing arrangement.

Over the past few years, financing for early stage companies has increasingly taken the form of convertible debt. Some estimates suggest that these notes are used in more than 2/3rds of startup seed rounds. Moreover, these notes may be collectively responsible for saddling thousands of startups with billions of dollars of debt. Ironically, very few players in the startup world anticipate these notes being repaid, but a number of founders and investors have expressed concern that these securities can potentially trigger significant consequences for a startup. Yet despite these shortcomings, convertible debt continues to enjoy prominence as a financing instrument primarily due to its expedient and affordable nature. Frustrated with the failure of the startup community to address this ailment, Adeo Ressi of the Founder Institute contacted Yokum Taku at Wilson Sonsini Goodrich & Rosati to try to create an alternative to convertible debt. In 2012, they proposed convertible equity as an alternative to debt financing. This alternative offers startups a new way to finance their company with the benefits of a convertible note while simultaneously eschewing some of its key drawbacks.

What is Convertible Debt?

Before exploring the benefits of convertible equity, it’s critical to understand why convertible debt is an attractive financing option for startups. Convertible debt is structured as a loan to the company by an investor that converts to equity in the company upon some future triggering event. Usually, this conversion occurs upon a “qualified financing,” in which the company raises a minimum, predetermined amount of cash in a Series financing. Sometimes convertible noteholders will negotiate valuation caps or discount rates to reward the investor for their risk in investing at such early stages. In this sense, convertible debt is meant to mirror traditional equity financing in many ways.

The allure of convertible debt primarily rests in how quickly these notes can be consummated without significant attendant legal fees. The entirety of a convertible note and its accompanying terms may be encompassed in a mere few pages. Moreover, convertible notes do not set a valuation on a company and can be negotiated independently with individual investors (i.e. a “rolling round”). As such, the legal costs are a fraction of the costs associated with a full equity financing.

What’s Wrong with Debt?

There are at least four issues with convertible debt that should give both founders and investors pause:

  • Maturation: First, convertible notes have a maturity date. Notes generally mature within one or two years of the loan’s issuance. In the best cases, when a startup fails to meet the note terms and cannot raise adequate funds in a qualified financing, the entrepreneurs must return to investors in order to renegotiate the loan terms. In a worst-case scenario however, investors can demand repayment of the loan. If even one investor demands repayment, it can trigger catastrophic effects for the startup that has to use much-needed funds to repay an investor. Finally, certain state laws require individuals to register as lenders if they extend loans for more than a year, imposing potential greater costs on the investors as well.
  • Interest: As a debt instrument, convertible notes also have an interest rate. While the interest is generally converted to equity upon a qualified financing, some have questioned whether levying interest rates on startups are appropriate from an optics perspective if the investors are genuinely acting as investors and not lenders. Additionally, managing various interest rates across different investors can be challenging and take away valuable product development time.
  • Insolvency: Former lawyer turned investor, Jason Mendelson, also highlights a potential consequence of convertible debt that has not received much attention in the media. Since convertible notes are debt, companies should recognize them as liabilities. Yet, because convertible debt usually converts to equity, few people actually recognize it as a liability on their balance sheets and financials. When properly recognized as a liability however, convertible debt may incidentally put many startups into insolvency immediately upon receipt, since few seed stage companies have any assets of significant value to offset these liabilities. In some states, courts impose additional duties and personal liability on directors towards creditors when a company is insolvent.
  • Creditworthiness: Finally, closely related to the insolvency issue is how convertible debt may impact startups creditworthiness. Again, because convertible debt is a liability, startups may have problems receiving credit lines or borrowing from traditional institutions if their balance sheets appear to be saddled with significant liabilities.

Convertible Equity

 Convertible equity is a type of security that seeks to remedy the aforementioned issues attendant with convertible notes. Generally speaking, convertible equity is a contractual arrangement wherein the investor agrees to contribute money to the startup in exchange for some future equity upon a qualified financing. Convertible equity functions similarly to convertible notes but eliminates two critical features of convertible debt: maturity dates and interest rates. The effect of eliminating these two aspects of convertible debt are best seen by considering the same factors that hamstring convertible debt:

  • Maturation: By eliminating the repayment feature, the threat of an investor demanding repayment and derailing the startup disappears. Investors no longer risk becoming lenders under most state law regimes, and founders can focus on developing products and services.
  • Interest: Without interest, startups don’t have to spend time managing complex financials and cap tables to keep track of various interest rates across noteholders. Philosophically, eliminating interest aligns these securities more closely with traditional equity financing as well, an initial inspiration for the creation of convertible debt.
  • Insolvency: Convertible equity can likely be recognized as equity on a company’s balance sheet, eliminating the risk of insolvency and unintentionally heightened duties owed to creditors. According to its creators, there may even be tax benefits if the securities can be qualified as qualified small business stock.
  • Creditworthiness: Finally, while it is unlikely that convertible equity can be used to significantly enhance a startups credit profile, it does not pose the same threat of harming a startup’s creditworthiness by saddling its balance sheets with liabilities.

Convertible equity can also be outfitted with most, if not all of the additional characteristics and rights of convertible debt such as valuation caps and discount rates. It can also include many of the rights offered in equity financing rounds, although negotiating these extensively would run up legal costs and mitigate any potential benefits for using convertible equity. Most importantly, because convertible equity is modeled after convertible debt, the deals can be completed just as quickly and cost effectively.

Is it right for you?

Despite emerging only three years ago, convertible equity shows signs of promise for many early stage ventures. There is at least one estimate that nearly 25% of recent early stage deals have used convertible equity, and in 2013 Y Combinator promulgated a set of convertible equity documents they dubbed the SAFE agreement (simple agreement for future equity). Yet, despite the increasing prominence of convertible equity, founders should still question whether pursuing this type of financing will be beneficial.

In making this choice, the considerations should be similar to those that arise when choosing between conventional equity financings and convertible debt. Is limiting the time expended raising funds important? Are you trying to minimize your legal fees? How sophisticated are your investors, and will they insist on negotiating for extensive rights as part of the financing? If expedience and cost are significant factors, convertible equity poses an attractive alternative to convertible debt for all of the above reasons.

The last hurdle startups may face is in convincing investors that are inexperienced with this form of financing that it’s a safe, viable alternative. As accelerators like Y Combinator move towards this model, more startups will find it easier to have this conversation with their investors, but convertible equity is still nascent. For this reason, startups in communities with more developed legal and VC practices such as those in Silicon Valley may find it easier to make the shift to convertible equity. With time however, I believe this form of financing will be more appropriate than convertible debt in many, if not most instances for early stage financings.

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Avoiding Misclassification – Employee or Independent Contractor?

KeAndraBBlogPic

In a previous post called “Hiring Tips for First Time Entrepreneurs,” we briefly discussed some of the factors considered by the IRS in classifying a worker as an independent contractor versus an employee (e.g. whether the worker operates under a separate business name, whether the worker uses his or her own tools for the job and sets his or her own working hours, and whether the worker serves more than one client). As the previous post noted, the IRS worker classification test centers around the degree of control or supervision the employer exercises over the worker. This post will break down some of the key additional factors that can help your startup determine whether to classify a worker as an employee or an independent contractor.

It is important for any business to avoid misclassification; however, it is even more important for a startup, because startups need to be especially careful with keeping costs and liabilities down, and the consequences of misclassification are expensive.  Misclassification can leave your startup subject to class actions and individual lawsuits, and liable for thousands of dollars in back wages, penalties, fines, workers compensation premiums, insurance contributions, and tax liabilities. So, the consequences of misclassification are serious, and your startup needs to be careful to avoid them. The IRS uses a test that focuses on three basic categories to weigh against each other and assist in making its determination on the question of whether a worker has been properly classified: (1) behavioral control, (2) financial control, and (3) type of relationship.

Behavioral: Does the startup control (or have the right to control) what the worker does for the startup and the method in which the worker does it? Ask yourself if your startup is doing any of the following:

  • providing training to the worker
  • giving detailed instructions on how to perform the task

If this is the case, your startup is exercising behavioral control over the worker, and this may favor classification as an employee. Independent contractors are usually just that—independent. This means they should have control over the methods they use in carrying out the task.

Financial: Does the startup control (or have the right to control) the financial/economic aspects of the work? Ask yourself if your startup is doing any of the following:

  • providing tools and supplies for the worker
  • reimbursing the worker for expenses
  • paying the worker a salary or guaranteed wage on a regular basis (e.g. a wage that is paid hourly, weekly, etc.)

If this is the case, your startup is exercising financial control, and this may favor classification as an employee. Independent contractors should be making their own investment into their business by covering their own expenses, and are typically paid a flat fee for their services.

Relationship: How do your startup and the worker perceive the relationship? Ask yourself if the worker is doing any of the following:

  • working for an indefinite period of time for your startup
  • receiving employee benefits from your startup (e.g. sick leave, insurance, etc.)
  • providing services that are integral to an essential part of your startup

If this is the case, the relationship favors classification as an employee. Independent contractors are usually hired for a specific period of time, do not receive benefits, and are not providing a service that is essential to the core of the startup’s business. Additionally, while the IRS does not have to confirm independent contractor status simply because an employer has a contract stating that the worker is such, it is helpful for your startup to have a contract in writing that (1) states that the worker is an independent contractor, and (2) explains the nature of the relationship in the context of the factors listed above.

Since the IRS weighs these factors, and working relationships evolve over time, it is likely not possible for an employer to know for certain that a worker has been properly classified. This is why it is important for your startup to do the following prior to classifying a worker: (1) review all of the factors provided by the IRS (located at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee), (2) put the agreement in writing, and (3) audit to ensure that your startup’s relationship with the worker is not evolving into one that would be considered an employer-employee relationship in view of these factors.

 

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A Primer on Privacy

The Public Trial of Samsung’s SmartTV

In early February 2015, Shane Harris at the Daily Beast reported on a provision in the Samsung’s Privacy Policy:

“Please be aware that if your spoken words include personal or other sensitive information, that information will be among the data captured and transmitted to a third party through your use of Voice Recognition.”

This clause sparked outrage, and comparisons to Big Brother in George Orwell’s 1984, online:

“Samsung’s Smart TV privacy policy sounds like an Orwellian nightmare” – The Verge

“Careful what you say around your TV. It may be listening. And blabbing.” – The Daily Beast

“Left: Samsung SmartTV privacy policy, warning users not to discuss personal info in front of their TV Right: 1984” – Parker HigginsEFF Activist (as shown in the above image)

Samsung was forced to act quickly. By amending its policy for clarity and revealing more about how the system works in a blog post titled “Samsung Smart TVs Do Not Monitor Living Room Conversations,“ the company attempted to stem the tide of complaints from privacy and consumer advocates. The voice recognition system would only be triggered by the user pressing a button on their television remote or the user stating one of the several predetermined commands. In the latter event, voice data is apparently not transmitted. Samsung also identified who the third party would be, Nuance Communications, Inc. Additionally, they guaranteed that it would be possible opt out of the voice recognition system entirely.

While the system Samsung described isn’t particularly novel, and likely doesn’t reveal anything secret, it did initially provoke some visceral reactions. The internet storm surrounding the policy started conversations, yet again, about the privacy practices of services and companies we engage with every day. For the entrepreneur, it should serve as a reminder and incentive to develop your policies early, review them often, and ensure compliance with your own polices. This post will serve as a primer on the essentials of privacy policies.

Privacy Policy Basics

 What is a privacy policy?

A privacy policy is a document that describes to users of your service, usually a website or mobile app, the data you will be collecting, how it will be collected, and how you will be using it. Depending on the nature of your website this data could range from usernames, email addresses, and very limited browsing information stored in a cookie to highly sensitive personal information such as credit card numbers, health records, personal names, and addresses. A privacy policy will typically discuss your intentions for the data and how it is stored and transferred securely. If you intend to process some information about your users for directed advertising, or sell user information directly, you should disclose information relating to what data is shared, what kinds of third parties (meaning companies the interaction with which the user will have no control over or possibly knowledge of) will be handling the data and how the data is secured.

Why do you need one?

In the US, there is no general federal requirement that a service provides a privacy policy. Instead it is a patchwork of statutes that cover services targeted to children (COPPA), financial services and banks (FCRA), and health-care providers (HIPAA), among others. However, some states have taken it upon themselves to mandate this kind of disclosure. Specifically, California requires “any commercial web sites or online services that collect personal information on California residents through a web site to conspicuously post a privacy policy on the site.” This may include posting the policy directly on your web site homepage, or linking to it using the word Privacy. Here is a more in-depth explanation.

Many countries and regions have created their own standards and regulations. The European Union has highly developed privacy law and has a set of principles endorsed through a directive: transparency, legitimate purpose, and proportionality. While the US government has created a program for US companies to comply with these principles, any company specifically planning to do business in Europe or collect data from individuals from the European Union should exercise great care. (For the curious, the summary article on Wikipedia is a quick introduction).

In the US, the Federal Trade Commission is responsible for regulating business practices and has the potential to issue fines for unfair practices. Failure to adhere to your own policies can be such a practice. The company facing liability may have acted deliberately, or may simply have inadvertently given access to an untrustworthy outside party.

Consumers are beginning to pay attention to privacy and security. As demonstrated by the Samsung debacle, a company that is clear, concise, and open with their privacy policies may have a leg up in organically growing goodwill while a company that is deceitful, deliberately confusing, or formalistic in their policies risks at best embarrassment and possibly outrage or loss of customers.

Lastly, if you plan to publish a mobile app, Apple, Google, and Microsoft may require a privacy policy accessible from your app or the respective store.

How do you write one and what should you be thinking about?

It is likely not wise to rely solely on a free privacy policy generator (easily found through an internet search). At the bare minimum, you should be highly critical of anything generated without an in-depth analysis of your business needs and practices. While writing your company’s privacy, you will want to consider:

1) What information are you collecting? What do you need?

Are you collecting everything just in case it becomes useful? Are you processing payment information or health information? Is your service covered by COPPA, or another special federal regulation? Are user interactions with the website tracked and logged?

Specifically identify the types of information collected.

2) How are you going to use and protect the data?

Are you recording information to improve usability and meeting consumer demand? Do you plan on generating revenue through targeted advertising? Is the information securely stored on servers you maintain or through another provider? Will the data be sent to outside companies and if so, what do their policies look like?

You don’t need to reveal secrets about your company’ strategy, and obviously you shouldn’t give away anything sensitive about your data security policies, but make sure your customers know their information is safe.

3) Are there chances that your uses will evolve?

This is where knowledge of your business plans becomes important. Are you engaging in a high growth model, with revenue to come later? Is it foreseeable that you may need to open up your data collection to another party for auditing purposes? How much control will you be giving to your users regarding storage of their information?  Even if you later revise your policy, you might need users to affirmatively opt-in to the revised policy in order for it to cover data collected under the prior policy.

4) How do you plan to notify your users of changes?

By being open (or even collaborative) with your users, you can quickly foster a sense of community and trust. In the alternative, by alerting them to updates to your policy or describing what was changed and why you can keep control over your terms without being seen as having an ulterior motive. It is important to designate the date your policy becomes effective for the initial version and each update.

5) How advanced will your user base be?

In some cases it may be preferable to provide an additional slimmed down version of your policy that explains your behavior in simpler terms. This could also be accomplished through creative uses of formatting and headings. There are a variety of approaches to this ranging from a basic approach to a sophisticated summary of terms.