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What’s So Great About a Delaware C-Corporation?

If you’ve spent any time looking at U.S. companies, you’ve likely noticed that an unusually large number are organized as Delaware C-Corporations. Similarly, many startup founders seeking to choose a business entity are counseled to form Delaware C-Corporations. But with so many great states to incorporate in, you’re probably asking yourself, “What’s so great about a Delaware C-Corporation?”

For many decades, Delaware has made itself the destination of choice for U.S. companies through its General Corporation Law. Delaware corporate law favors directors and minority shareholders relative to other states, provides for tough antitakeover laws, and protects the identifies of shareholders and directors. These policies are thought to attract businesses on the theory that the directors and managers enjoy better flexibility and protections. Additionally, Delaware’s non-taxation of royalty payments allows corporations to avoid some tax in other states by transfering intangible assets to Delaware.

Once a business is based in Delaware, disputes are litigated in front of the Court of Chancery, perhaps the most well-known advantage of doing business in Delaware. The Chancery Court is one of the nation’s oldest equity courts and it spends almost all of its time hearing corporate cases, typically without a jury. As a result, the five judges of the Chancery Court are some of the nation’s leading experts in business law who are capable of hearing and deciding complex corporate cases with remarkable efficiency and understanding. Additionally, the extensive case law coming out of the Chancery Court has created a well-known and predictable set of rules for corporations in the state.

It is important to note, however, that Delaware is not the only state competing for businesses and there is some evidence that the benefits of a Delaware C-Corporation are minimal or fail to justify the costs. In the face of this evidence, the fact that Delaware continues to be the go-to state for C-Corporations illustrates one of its most significant advantages – inertia. Delaware’s long-standing reputation means that today’s corporate lawyers often choose Delaware by default. Venture capitalists and angel investors generally require a Delaware C-Corporation, as do many investment bankers looking to take a company public. In general, a Delaware C-Corporation is a signal to the market that you’re a “serious” company. For all of these reasons, Delaware is unlikely to lose its favored status in the near term.

The benefits of a Delaware C-Corporation include the state’s corporate and tax laws, the Court of Chancery, and the inertia created by decades of developing a business-friendly reputation. While a Delaware C-Corporation doesn’t make sense for many startup companies, a significant portion of successful startups will end up converting to that form. In any case, these advantages illustrate why so many companies are formed as Delaware C-Corporations and why that that will continue to be the case in the foreseeable future.

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Donald Trump and Start-Ups

Hillary Clinton received 64 million (and counting) votes in the 2016 Presidential election and one of the driving factors behind that was the uncertainty of policies in a Trump presidency. However, as the dust settles and Americans face the inevitable, we need to start to look at exactly what Trump’s America is going to look like. This post discusses the potential changes Trump’s policies have in two major areas of start-up law: trade and immigration. Many worry that the broad, sweeping language of Trump’s campaign does not bode well for Silicon Valley.

 

Potential Trade Impact

A large portion of Trump’s campaign was spent attacking U.S. trade policies — including the North American Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP) — and promising to slap high tariffs on (mainly Chinese) imports. The reneging of trade agreements and the imposition of high tariffs could have potentially devastating effects on Silicon Valley. The tech industry is very reliant upon cheap labor in Asia (including China, Vietnam, and Taiwan) to mass produce all components for smartphones, robots, computers, and tablets. An iPhone 7 is currently costs a minimum of $649 (plus tax) and one can only imagine how a steep tariff or forced manufacturing in the U.S. would affect the price. After all, the consumer will surely bare the cost of Trump’s policies. As CNN Money reports, manufacturing jobs pay an average of $20.17/hour—almost three times the federal minimum wage of $7.25/hour. Another issue with the promise to bring manufacturing jobs back is that those jobs are not great jobs to begin with—with manufacturers earning a little over $53,000 per year, putting them firmly in the lower middle class. Compare this to workers in China who, according to China Labor Watch, earn about $750/month with overtime.

Even though NAFTA, enacted in 1994, actually increased the amount of manufacturing jobs in the United States, Trump is correct about manufacturing being drawn away from the U.S. CNN Money reports that the U.S. has lost 5 million manufacturing jobs since 2000. However, this is a general trend that goes back to the 1960s. At that time, manufacturing jobs made up 24% of the labor market; this decreased to 19% in 1980; to 13% in 2000, and now to just 8% in 2016. However, the problem with Trump’s thesis is that technology has taken on a huge role in the manufacturing sphere — with robotic manufacturing becoming more and more the trend and the jobs associated with those robots requiring more and more education — leaving those who are not educated even less likely to find jobs.

This trend has even taken place in China where we see companies like Foxconn Technology, best known for their mass production of Samsung and Apple parts, replacing as many as 60,000 workers with robots in just one factory alone. As the Washington Post explains, “[This] is the natural dynamic by which market economies become richer as productivity improves. Improvements in agriculture productivity led to a wave of migration of farm workers to cities, where they provided the manpower for an industrial economy that eventually became so productive that we could afford to buy more health care, education, and yes, government.”

In short, Trump’s promises to limit trade are going to be more helpful as campaign rhetoric than actual policies. Manufacturing in other countries gives U.S. consumers and businesses access to low priced goods, which in turn drive the price of those goods down in the U.S. market. These policies have a chance to have a devastating impact on the American economy as a whole, but especially for Silicon Valley technology hardware firms.

 

Immigration and Visas

Another one of Trump’s main issues was immigration; more specifically, the need to limit future immigration and reverse past immigration. Silicon Valley as a whole has pushed hard to expand the use of H-1B visas beyond the 85,000 cap. The H-1B visa is a non-immigrant visa that allows U.S. companies to employ “foreign graduate level workers in specialty occupations that require theoretical or technical expertise in specialized fields such as in IT, finance, accounting, architecture, engineering, mathematics, science, medicine, etc.” To obtain an H-1B visa, an employer must offer a job to the worker and apply for a H-1B petition with the U.S. Citizenship and Immigration Services.

Silicon Valley relies heavily on immigrants — according to Bloomberg News, over 50% of U.S. tech startups valued at $1 million or more have at least one immigrant founder. Additionally, immigrants are heavily involved in the workforce in Santa Clara and San Mateo counties, which are prominent in Silicon Valley. Bloomberg reports that over two-thirds (67.3%) of the workforce in computer and mathematics fields are foreign-born, 60.9% in architecture and engineering, 48.7% in natural sciences, 41.3% in medical and health services, 41.5% in financial services, and 42.7% in other occupations. In short, immigrants make up a substantial portion of all workforce areas in Silicon Valley.

This is in addition to the so-called “startup visas,” which the Obama Administration pushed through without Congress. These visas are given to entrepreneurs who own at least 15% of a U.S. startup, and who can demonstrate the company’s growth potential, have investments from qualified U.S. investors, and provide a “significant public benefit” to the U.S. Visas are granted for two years, but the recipient can apply for an additional three years as the company proves its benefit to the American public. The recent announcement of these startup visas was well received in the tech world.

Trump has flip-flopped back and forth on whether H-1B visas are a way to bring in skilled workers or a way to bring in cheap international labor. According to the Verge, workers on H-1B workers had a median salary of $75,000 as of two years ago. In the Verge, Economist Rob Atkinson argued that the most likely outcome in a Trump White House is that “H-1B visas “will be restricted, limited, and harder-to-get” and that tech companies will “have to go through more hoops to prove there’s not an American that can get the job.” Trump’s tough talk on immigration and handing visas to skilled workers could eventually have the effect of sending jobs outside the country. If the U.S. government prevents Amazon and Microsoft from hiring the best engineers, it is only logical that they might look to set up bases in other countries (such as Canada) where their access to the world’s talent pool would not be limited.

 

Conclusion

Donald Trump’s rhetoric regarding trade and immigration in his campaign have many worried about the impact his policies will have in Silicon Valley. Silicon Valley (and the tech industry as a whole) rely heavily on cheap manufacturing abroad and imported brain power to fuel the tech industry. A fight to keep manufacturing alive in America despite its inevitable death could just wind up costing the U.S. in the form of higher priced goods. And an attack on immigration fueled by the H-1B visa could “brain drain” the U.S. and drive some of the most innovative minds (and their companies) away from the U.S.

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Buy-Sell Agreements: Why Every Business Needs One

A buy-sell agreement is a necessity for any co-owned startup business. Most entrepreneurs don’t spend a lot of time thinking about their eventual departure from their recently formed startup, but a set of rules detailing the terms and procedures of the inevitable parting can obviate countless headaches in the future.

 

What is a Buy-Sell Agreement?

Buy-sell agreements define and govern the rules of transferring corporate stock[1] in the event a shareholder decides to transfer, gift, or otherwise relinquish her shares. The agreement generally defines and controls 1) who is eligible to purchase the shares, 2) which events trigger a right to purchase the shares, and 3) the terms and conditions of the purchase.

Buy-sell agreements can include a wide array of common provisions depending on what the company and shareholders are trying to accomplish. These agreements typically answer questions such as: Is a shareholder’s family entitled to her shares upon the shareholder’s death? Does the family acquire all the rights of the deceased shareholder? Can a company repurchase the stock of a shareholder who was recently convicted of a serious felony against the shareholder’s wishes? How is the purchase price decided? Are there limits on when or to whom shareholders can sell their stock? The purpose of a buy-sell agreement is to provide answers to these questions, and many more. Having a clear set of stated rules can prevent a wide array of different kinds of disputes between co-owners in the event of a potential sale.

 

Common Provisions

Right of First Refusal – A right of first refusal is a popular provision in buy-sell agreements and requires a selling shareholder to offer her stock to either the corporation or remaining shareholders before she sells to a third-party. The terms of the sale to the corporation or shareholders often must match or exceed the established arrangement with the third-party.

Example – Sara wants to sell her shares and finds a buyer in Billy, a third-party, who agrees to buy all her shares for a total of $1,000. A right of first refusal gives the company and/or remaining shareholders the right to purchase Sara’s shares in lieu of Billy, but only at a price of $1,000 or greater. Sara is allowed to sell her shares to Billy only if the corporation and the shareholders do not exercise their right to purchase her shares.

Analysis – A right of first refusal allows the company to “keep it in the family.” It obviates the risk an outsider might bring to the company. Many closely held companies implement rights of first refusal to prevent unwanted third-parties from becoming a shareholder.

This right also assures the seller a fair price for her stock. If the company does not want a third-party to become a shareholder, it must match the price offered to the seller, effectively the fair market value.

 

Right of First Offer – A right of first offer acts in a manner similar to a right of first refusal, but instead allows the seller to offer her shares to the corporation BEFORE finalizing terms with an outside party.

Example – Sally decides to sell her shares and offers to sell them to the company for a total of $1,000. If the corporation declines her offer, Sally is then free to sell her shares to any third-party for a price greater than or equal to $1,000.

Analysis – A right of first offer, as opposed to a right of first refusal, is more advantageous to the seller. Rights of first refusal tend to dampen the value of a seller’s stock because potential buyers understand their offer will likely be negated when the company decides to purchase the seller’s shares. As a result, many potential buyers refuse to put forth the due diligence required in researching the purchase. Potential buyers in a right of first offer, on the other hand, know they will not face the same barrier and are more willing to invest the time and effort required before such a purchase. Consequently, sellers attract more interest when they are restricted only with a right of first offer, as opposed to a right of first refusal.

 

Option – An option to repurchase gives the company and/or other shareholders the right to repurchase the stock from another shareholder upon certain triggering events. The declaration of bankruptcy, filing for divorce, conviction of a felony, and termination of an employee-shareholder are all examples of events that might trigger an option to repurchase the stock of the respective shareholder. Because options, unlike rights of first refusal or rights of first offer, do not inherently include an offering price, the buy-sell agreement should establish a method of valuation for the stock.

Example – Fred was convicted of murder and sentenced to twenty years in prison. Such a felony was listed as a triggering event in the buy-sell agreement. The company now has the option to repurchase Fred’s 100 shares, regardless of any possible objections from him. The buy-sell agreement specifies that, in the event of an option to repurchase, the company will pay the selling shareholder $50 per share. If the corporation decides to exercise its option, it must pay Fred $5,000 for his 100 shares.

Analysis – Options give the corporation a way to mitigate potential harm caused by certain “triggering events.” Fred is unlikely to add value (and can potentially contribute a significant amount of harm) to the company from prison during the next twenty years. The option gives the company a way to divest from Fred and put his shares to better use elsewhere.

 

Drag-Along – A drag-along gives a company the right to require its shareholders to participate in the sale of the company.

Example – Matt is the majority shareholder (80%) of a company and would like to sell his shares. Abe wants to purchase the company, but he is only interested in purchasing the entire company. He is not interested in acquiring only 80%. Mitchell, the minority shareholder (20%), has no desire to sell his shares. The drag-along provision forces Mitchell to sell his shares to Abe along with Matt.

Analysis – Drag-along provisions prevent holdouts. Companies often have many shareholders, and not every shareholder is always eager to sell. Without a drag-along, a single shareholder could potentially block the sale of a company initiated by a majority of the other shareholders.

Drag-alongs also benefit minority shareholders. With a drag-along provision in place, otherwise powerless minority shareholders do not have to worry about other “holdout” shareholders blocking a valuable transaction.

 

Tag-Along – A tag-along gives shareholders the right to include their stock in the sale of another shareholder’s stock. The shareholder exercising his tag-along right is often entitled to the same terms and conditions agreed to between the initial seller and third-party.

Example – Samantha, who currently owns 80% of a company, wants to sell all her shares to Iris for $100/share. Tiffany, who currently owns 20% of the company, does not want to be involved in the company without Samantha. Tiffany can exercise her tag-along right and force Samantha and Iris to include her shares in their transaction with the same terms and conditions. Because Tiffany’s shares are now tagging-along with Samantha’s shares in the transaction, Iris can no longer only purchase Samantha’s 80%. She must either purchase both Samantha’s and Tiffany’s shares, which would give her 100% of the company, or purchase nothing. If she decides to proceed with the purchase, she must also pay Tiffany $100/share.

Analysis – Tag-alongs are often in the best interest of minority shareholders. If a majority shareholder decides to sell his shares, it is often because he received a favorable price. A tag-along prevents the minority shareholder from getting stuck with the third-party purchaser. Instead, she can exercise her tag-along right and sell her shares at the same favorable price received by the majority shareholder.

 

Rights of first refusal, rights of first offer, options, drag-alongs, and tag-alongs are just a few of the common provisions found in buy-sell agreements, yet each wields tremendous sway in determining whom a corporation’s shareholders will be and how much power and interest those shareholders will have. Every entrepreneur should take great care in structuring a buy-sell agreement. The time and effort that goes into it may not seem worthwhile at the time, but it could prove priceless down the road.

[1] This article refers to shareholders and stock within the corporate structure, but the same principles apply to any co-owned company (e.g., members and units within an LLC as well as partners and interest within a partnership).

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The Pros and Cons of New Online Legal Services

It can be difficult to assess the credibility of the many available reviews of non-traditional legal service providers, as many critics, like law firms and established service providers, have a vested interest in discrediting the services. However, it is worth noting that the services have very real issues and limitations. Here we will consider two new types of legal services, non-firm affiliated online legal service providers such as Rocket Lawyer and Legal Zoom, and firm-affiliated online legal resources, such as Cooley GO, and assess their pros and cons for entrepreneurs.

 

Non-Firm Internet Legal Service Providers

In the last fifteen years, legal services have come to the internet. In 2001, LegalZoom, the first of these non-firm online legal service providers was founded. Rocket Lawyer, LegalZoom’s biggest competitor, joined the market in 2008. Both use similar models to offer three types of services. First, they provide document generators for a number of matters, from wills and trusts to entity formation. Second, they provide limited consultation services, connecting customers to affiliated attorneys. For the second function, the two companies differ slightly. Legal Zoom offers a subscription model matching you with a lawyer that you may consult with for a specified amount of time each month. Rocket Lawyer offers “on call” attorneys that will answer discreet questions at any time, for a fee. Legal Zoom offers an on-call service, but their service connects customers with “specialists” rather than attorneys. Finally, both services post articles on legal matters, such as articles detailing the pros and cons of LLCs and corporations.

The most obvious advantage of these companies over a traditional law firm is cost. Costs of these services are quite low. Formation of an LLC with LegalZoom, including filing fees, can be done for $149, and their subscription model begins at $31.25 per month. Hourly rates for lawyers at big law firms are usually several hundred dollars.

These companies may be especially useful to entrepreneurs with a broad variety of legal issues, not all of which relate to their company. Unlike the firm-affiliated services discussed below, LegalZoom and Rocket Lawyer also provide documents and information for personal legal issues. Like the services discussed below, these companies will also likely be useful to very early-stage companies wishing to get the lay of the land before proceeding with other types of counsel.

However, there are important downsides to these services that should not be dismissed. First, for entrepreneurs in relatively small legal markets such as Ann Arbor, the counsel accessible through these companies may not be able to provide market-specific insights, and will likely only be able to provide a national perspective. For example, LegalZoom’s subscription service is not available in Michigan at this time. This can be especially important when forming a company: if you choose to form an LLC, you will most likely form that LLC in the state in which you are located, and the laws relating to LLCs and other entities vary by state. Second, both LegalZoom and Rocket Lawyer disclaim all liability stemming from use of their documents. This means that if you use their document and later discover, for example, that a provision is unenforceable, you have no recourse against the company. This is not the case if you hire counsel to review or draft your documents. It should be noted that the accuracy of the documents may be a real issue. A number of practitioners have publicly criticized the quality of the documents, and the documents may not be updated promptly to reflect changes in the law or the market.

 

Online Firm Resources

Many law firms that service startups have responded to this increased availability of legal services on the internet by creating their own platforms for entrepreneurs to get information and begin building their business. One such service, Cooley GO, is provided and maintained by Cooley LLP, a law firm based in Silicon Valley that specializes in counseling startups. Cooley GO provides a number of resources, including articles written by Cooley lawyers on topics important to entrepreneurs and document generators. On Cooley GO, entrepreneurs can read articles answering questions on many aspects of their business, including “what entity form is right for me?” and “what factors do I need to consider when allocating equity?” and advice on seeking venture capital and other financing. In addition, Cooley GO provides a document generator that allows entrepreneurs to input their information into a form and generate documents such as the full suite of documents necessary to incorporate, and different employment documents.

These websites can be very beneficial to entrepreneurs because, unlike Rocket Lawyer and LegalZoom, these websites are tailored specifically to their needs and come from firms with particular expertise in their issues. Rocket Lawyer and LegalZoom both cover a broad range of issues and as such provide less industry-specific expertise, and in fact both websites were originally intended for personal rather than business services. However, the important caveat to this benefit is that services like Cooley GO only provide resources for entrepreneurs and their legal issues. Answers to other legal issues individual founders may have that are tangentially related to their business will not be found on Cooley GO.

In addition, as discussed throughout this article, the advice offered throughout Cooley Go and other similar services are not personalized, and no regional advice is available. Further, the document generators suggest you consult a lawyer and no guarantee is made as to their accuracy. Finally, unlike the online services discussed above, there is no instant way to consult a lawyer through Cooley GO. However, using Cooley GO can provide a gateway to engaging the services of a Cooley attorney. While engaging an attorney may be expensive, many startup-focused law firms offer deferred payment plans for early-stage companies.

 

Traditional Counsel

While these services provide a wonderful jumping-off point for entrepreneurs looking to familiarize themselves with the legal landscape, there is no substitute for counsel. While in all circumstances the judgment and expertise counsel can provide are helpful, there are some circumstances in which hiring counsel is especially important.

First, when you have questions relating to a very specialized area of law, such as immigration or tax law, counsel in those issues can guarantee the matter is handled correctly. Second, if you are negotiating an agreement or term sheet it is important to hire counsel to advocate on your behalf. In that situation, counsel can also assess whether or not the terms you are being offered are market and help you evaluate your options. Third, if your matter involves any intellectual property, you should hire counsel to ensure that you are legally protecting your intellectual property in both the short and long term. Unfortunately, some actions may void your rights to protections such as a patent, so involving counsel early ensures you keep all your options open. Fourth, if you are looking for connections to other resources in the community, such as incubators, financing, or other entrepreneurial services, hiring counsel can allow you to connect with those services more easily. Finally, if your situation differs from “the norm” in any way or specifically requires a judgment call, hiring counsel is critical. The documents provided both by services such as LegalZoom and Rocket Lawyer, and Cooley GO are sufficient only for the most basic and typical of situations.

The Michigan Law Entrepreneurship Clinic can be a perfect option for many area entrepreneurs. In addition to providing the benefits just discussed that come with obtaining counsel, the services of the Clinic are pro bono, meaning no hourly rate for the services is charged. Some matters are outside of the scope of the clinic, but in those situations the Clinic can refer you to local counsel that would be a good fit for those particular issues, allowing you to spend money just on those matters that really require it. Applications for Clinic services are evaluated on a rolling basis, and may be submitted here.

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Incorporating Online Terms By Reference: Avoid the Common Mistakes

Terms of Service agreements are used to outline the legal relationship between a party providing a service and a party receiving or using a service. The Terms typically include contractual components such as definitions, rights and responsibilities, and representations and warranties. Service providers may offer Terms of Service in several ways, including by paper, by attachment to an order form, or during the process of “click through” ordering, either on a website or mobile application. Additionally, service providers are increasingly providing their Terms of Service online, and incorporating them into contracts and order forms by reference.

 

Benefits of Incorporating Online Terms of Service By Reference

Incorporating Terms of Service by reference can provide several advantages over traditional methods. First, incorporating online terms significantly reduces the amount of physical paper used by both parties. Reducing paper consumption and waste is not only an increasingly popular initiative for companies concerned about the environment, it can also increase efficiency and reduce costs.

Second, incorporation by reference allows companies to establish uniformity across all of their contractual agreements. Service providers often contract with hundreds or thousands of customers, and the more consistency those agreements have, the less time and effort is required to track, analyze, and report the company’s legal exposure.

Another valuable benefit is the ease with which a company can rollout updates to its standard Terms of Service. By incorporating Terms by reference, a company can simply update the agreement online and it will subsequently apply to all contractual provisions that incorporate those terms (assuming the incorporation language is worded correctly, as discussed below). This method of updating standard terms by one upload can save massive amounts of time as compared to the alternative: sending the updated terms individually to every customer.

Lastly, providing terms online offers customers a valuable, easy-to-access portal to the contractual agreement. Customers can certainly retain their own copies, but online availability can provide a quicker, easier resource than clunky contract retention systems.

 

Are Incorporated Terms Enforceable?

While the digitization of traditional business practices is nothing new, incorporating online terms into purchase orders is a relatively recent development. Yet courts at both the federal and state levels have held such incorporated terms enforceable, and several courts note that failing to inquire about incorporated terms is no defense. Where courts have found terms unenforceable, the incorporating language did not make clear that the online terms were binding.

Additionally, all U.S. states but Washington and Georgia have adopted the Uniform Electronic Transactions Act of 1999 (“UETA”), which states, “a contract may not be denied legal effect or enforceability solely because an electronic record was used in its formation.” However, under the UETA, the electronic records must also be “capable of retention by the recipient.”

Another issue is the enforceability of updates to the incorporated terms. While few courts have considered the issue, generally it appears courts will uphold updates as enforceable when the party to be bound was made aware that updates could occur, even if the party is not provided notice of the actual update. In Briceno v. Sprint Spectrum, L.P., a Florida appellate court held a customer was bound by updated terms because the invoice noted that the terms could be periodically updated.

 

Best Practices for Incorporating Online Terms

To ensure enforceability, companies should not simply state the location to find additional terms. Companies must state the binding nature of the terms in clear, specific, and conspicuous language (e.g., “Parties agree to be bound by the terms of this order form as well as ACME’s Service Terms found at www.acme.com/Terms.”).

Additionally, companies must be sure to provide incorporated terms on an easily accessible website. Companies should not use barriers like login requirements or other security measures that make it difficult for the counterparty to copy, download, or print the terms.

Even if enforceable, companies should consider the best way to apply updated terms to their contracts. Some companies do not have long-term agreements with their customers, and each purchase order constitutes a new contract. For these types of relationships, it likely makes sense for updated terms to apply immediately to any new purchase orders.

Other companies maintain existing contractual agreements with their customers, and each purchase order may simply constitute a means for the customer to request goods, or to periodically change business terms, such as upgrades to the number of subscriptions or users, within the overarching framework of a master agreement. For these companies, it may be contrary to their customers’ expectations if, for example, a simple user upgrade suddenly binds them to an entirely new and different set of terms than had previously governed the relationship. Additionally, for these customers, having different subsets of users bound to different terms may unnecessarily complicate the contractual situation rather than streamlining it.

Lastly, companies should consider whether it’s even desirable for standard terms to apply to all of their customers. If customers are situated in a variety of international jurisdictions, or if customers have widely divergent needs, it may be advisable to tailor contractual terms to the different customer bases.

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Linking to Copyrighted Content: Not a Foolproof Way of Avoiding Infringement Liability

There is a common misperception that “linking” to copyrighted content on other webpages, instead of simply copying and pasting an image, for example, is a foolproof way of avoiding liability for copyright infringement. However, students, internet users, and startups without experience in the field of copyright should be aware that this is not always true.

The Berkman Center for Internet and Society’s Digital Media Law Project splits the practice of “linking” into two categories — “deep linking” and “inline linking.” “Deep linking” refers to “placing a link on your site that leads to a particular page within another site (i.e., other than its home page).” The ABA’s Intellectual Property Litigation states that “a majority of courts have agreed that merely linking to another site (whether in the form of a simple link to another website’s homepage or a deep link to a specific page on another website) does not constitute copyright infringement.” The ABA bases this conclusion on the clear statement made by the Federal District Court for the Central District of California in Ticketmaster v. Tickets.com that “hyperlinking does not itself involve a direct violation of the Copyright Act (whatever it may do for other claims) since no copying is involved.” The Electronic Frontier Foundation’s Internet Law Treatise also cites Arista Records, Inc. v. MP3Board, Inc. (holding that linking to content does not implicate distribution rights and thus, does not give rise to liability for direct copyright infringement), and Online Policy Group v. Diebold, Inc. (holding that “hyperlinking per se does not constitute direct copyright infringement because there is no copying”) to support the conclusion that mere linking does not violate the Copyright Act.

The Berkman Center defines “inline linking” as “placing a line of HTML on your site so that your webpage displays content directly from another site” commonly referred to as “embedding.” The Berkman Center relies on Perfect 10. v. Google in concluding that “while there is some uncertainty on this point, the Ninth Circuit concluded that inline linking does not directly infringe copyright because no copy is made on the site providing the link; the link is just HTML code pointing to the image or other material.” Rightfully so, the Berkman Center cautions that other courts may or may not follow this reasoning.

If you are feeling that the above analysis seems unsettlingly inconclusive, your uneasiness is well warranted. The Berkman Center points out that there still may be liability for linking: when either 1) the linking is to infringing works, or 2) the linking is to circumventing technology proscribed by the Digital Millennium Copyright Act (DMCA). The first circumstance arises when you knowingly link to works that clearly infringe someone’s copyright, “such as pirated music files or video clips of commercially distributed movies and music videos.” Such linking may give rise to a specific kind of secondary liability called “inducement,” which occurs by “intentionally inducing or encouraging direct infringement.” Metro-Goldwyn-Mayer Studios, Inc. v. Grokster, Ltd., (holding that one who distributed a device with the object of promoting its use to infringe copyright, as shown by clear expression or other affirmative steps taken to foster infringement, is liable for the resulting acts of infringement by third parties). The Berkman Center instructs that “as long as you do not know that a work infringes someone’s copyright, then you cannot be held liable for contributory infringement for directing users to that work.” However, “on the other hand, it is not necessarily safe to simply claim that you ‘didn’t know’ when the circumstances make it clear the material you link to is infringing.” The Berkman Center also suggests that you may be able to avoid liability in these circumstances by following the notice and take down procedures of the DMCA.

The second circumstance pertains to §1201 of the DMCA, which makes it illegal to traffic in technology that enables others to circumvent technological measures put in place by copyright holders to control access to or uses of their copyrighted works. Trafficking is defined as “making, selling, giving away, or otherwise offering” these devices or tools to the public. Simply posting such tools to your website (which can consist of merely reposting a combination of numbers and letters that you know represent a circumventing code) or linking to other websites that host them qualifies as trafficking, as described in Universal City Studios, Inc. v. Corley, (holding that hosting and linking to the DeCSS code, which allowed users to circumvent CSS, the encryption technology used by movie studios to stop unlicensed playing and copying of commercially distributed DVDs, violated the DMCA’s anti-trafficking provisions, and this application of the DMCA did not violate the First Amendment).

In light of this analysis, it is clear that simply linking to copyrighted content on other webpages, instead of copying that content directly onto your webpage, is not a foolproof way of avoiding liability for copyright infringement. An experienced copyright attorney, or established company with in-house counsel, will likely be sufficiently knowledgeable and savvy to recognize, and avoid linking to, content from webpages that is clearly infringing or has circumventing instructions in violation of the DMCA. However, students, internet users, and startups who are not as savvy, or do not have in-house counsel, may be happy to knowingly deep link or inline link to a clearly infringing photograph, video, or song, and thus should be on notice that such behavior may subject them to copyright infringement liability.

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Taxation of Grants and the Contribution to Capital Exception

As an early stage startup, companies are generally scrambling for funding and looking in any number of places to secure it. One key source of funding that is often overlooked is a grant. While grants come in various shapes and sizes, one of the most attractive aspects of many grants is that the granted funds need not be repaid, and the grantor does not acquire an equity stake in the startup. This allows an early stage startup to acquire funding for its business while not diluting the founders’ ownership stake. Grants come in all shapes and sizes, including public grants from state or federal government. While grants are often optimal sources of funding, most grants are still taxable income.

Section 61 of the Internal Revenue Code (“IRC”) defines gross income to mean “all income from whatever source derived.” As a result, generally speaking, grants are considered gross income and, like most gross income, grant money is taxable. This includes both government and private grants.

However, under certain circumstances, grants from government entities may be exempt from taxation. The most notable, and relevant exception is called the Contribution-to-Capital (“CtC”) exception. According to §118(a) of the IRC, a business need not include shareholder contributions to capital as gross income for tax purposes. Furthermore, under certain circumstances, contributions to capital from non-shareholders also qualify for the CtC exception. According to United States v. Chicago, Burlington & Quincy Railroad, 412 U.S. 401 (1973), in order to qualify for the CtC exception, the grant must have five characteristics: (1) the contribution must become a permanent part of the transferee’s working capital structure, (2) the grant money cannot be compensation for goods or services, (3) the contribution must be bargained for, (4) The contribution must foreseeably benefit the transferee in an amount commensurate with its value, and (5) the contribution must ordinarily be employed to generate additional income. In the case of a non-shareholder contribution to capital, the contribution must come from some governmental unit or civic group.

While § 118(a) sounds simple enough, it remains a source of considerable controversy and bares special consideration. First, and most obviously, the CtC exception only applies to corporate taxpayers, meaning LLCs are not eligible for the CtC exception. However, because the process of converting from an LLC to a C-Corp is generally quick and straightforward, an LLC may choose to convert to a C-Corp if it believes that the company has a relatively high probability of obtaining a CtC grant. Startups should balance the costs, both direct and indirect, of the conversion process with the potential money to be retained as a result of the CtC exception. For startups receiving only minimal grant money, the additional formality and structure of a corporation may not justify the small retention of money created through the CtC exception.

Next, the exception only applies when grant money is invested in real, depreciable capital. Therefore, startups that do not plan on using the windfalls of grant money on depreciable capital cannot avail themselves of the CtC exception. For example, many startups in the tech space often need to invest a great deal in hiring labor. However, using grant money to pay the salary of an employee or independent contractor would not be considered a contribution to capital and is therefore not eligible for the CtC exception.

Finally, startups should not make uninformed assumptions regarding whether the CtC exception applies to grant money received. The CtC exception is very narrow and the IRS has taken a decidedly stringent stance when deciding if the CtC exception applies, designating non-shareholder contributions to capital a Tier 1 examination issue. Startups should consult a tax-attorney or accountant when considering use of the CtC exception.

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Series LLCs: An Uncertain Innovation

joegallmeyerblogpost

Given the ubiquity of the LLC today, it’s easy to forget that in its early days the LLC wasn’t always the go-to legal form for founders who wanted the benefits of limited liability without the hassles of incorporation. As Vicki Harding notes in an article in the Michigan Business Law Journal, when the LLC was still a novel legal construct, founders often shied away from the form. In those early days, it was not clear how courts in states without LLC statutes would treat LLCs that had been formed in other states. Faced with this legal uncertainty, founders elected to form more traditional legal entities rather than risk an adverse judgment in a state court that refused to recognize the LLC’s liability protections. Today, a similar phenomenon can be seen in a more recent legal innovation: the series LLC.

A series LLC is a group of limited liability entities that operate under one parent entity that is registered with the state. The parent is usually referred to as the “series LLC,” and the constituent entities are called “series.” Each series is treated as an independent LLC with its own assets and liabilities. Creditors of one series cannot reach the assets of another series.

While series LLCs are often associated with venture capital funds and real estate management companies, entrepreneurs who want to engage in multiple “synergistic” lines of business might be drawn to the form, too. A tech startup, for example, might want to simultaneously explore several potentially viable lines of business. The series LLC would allow the tech startup to do that, while protecting each line of business from the liabilities of the others. The startup could create the same liability structure by founding several independent LLCs, but that approach would typically involve more work and more taxes and fees. Often, forming a series LLC is a thriftier alternative.

However, there’s a catch. Only a few states have adopted series LLC laws, and the courts in states without series LLC laws may not recognize the liability limitations series LLC laws provide. Founders who wish to operate in states without series LLC laws should consider whether the benefits of forming a series LLC outweigh the risks posed by the legal uncertainty surrounding their liability limitations.

Whether this uncertainty will ever be resolved is an open question. It doesn’t look like the series LLC is catching on as quickly as the LLC did. The first series LLC statute was passed twenty years ago, and next year marks the fortieth anniversary of the nation’s first LLC statute. The series LLC is already half as old as the regular LLC, yet little progress has been made toward its nationwide adoption. Ten years ago, the National Conference of Commissioners on Uniform State Laws declined to introduce series LLCs into the Revised Uniform Limited Liability Company Act. Vicki Harding reports that the Commissioners found “difficult and substantial questions remain[ed] unanswered,” including whether the series form would be respected in state courts of states without series LLC laws. They concluded that “[g]iven the availability of well-established alternative structures (e.g., multiple single member LLCs, an LLC ‘holding company’ with LLC subsidiaries), it made no sense for the Act to endorse the complexities and risks of a series approach.” To date, only eleven states (Alabama, Delaware, Illinois, Iowa, Kansas, Missouri, Montana, Nevada, Oklahoma, Tennessee, and Texas), the District of Columbia, and Puerto Rico have adopted series LLC laws. In non-series states, there seems to be very little case law on series LLCs, perhaps because few people form series LLCs for out-of-state operations. For example, no Michigan court has had occasion to rule on whether series LLCs are effective in Michigan.

Is it worth it?

For founders of entities that will do business only in a series-LLC state, forming a series LLC in that state is a low-risk option (provided of course there’s no reasonable likelihood the entity will be subject to suit in a non-series state). In series-LLC states, entrepreneurs participating in the local business scene (e.g., restauranteurs, property managers, independent retailers) might find that forming a series LLC saves them time and money.

Founders who will do business in non-series states need to consider whether the advantages of the series LLC outweigh the risk that a state court could hold the entire series LLC liable for the obligations of one of its constituent series.

Some states, like Illinois and Delaware, have higher than average franchise taxes and filing fees. In Illinois, it costs $750 just to file articles of organization for a series LLC. In Michigan, you could file fifteen separate LLC articles for the same amount of money. The entrepreneur will have to do the math, but in some cases it could be cheaper to form multiple regular LLCs, even before discounting for the risky nature of series LLCs.

Can a series LLC preserve limited liability when it operates out of state?

If a founder is willing to risk forming a series LLC that will operate in non-series states, he or she should carefully consider where to form the series LLC. Series LLC laws differ slightly from state to state, and those differences may have interesting legal implications for a founder who wants to operate a series LLC in a non-series state. For example, Vicki Harding explains that an entity that registers under Illinois law can obtain from the Illinois government a certificate of good standing for any single series in its series LLC. The entity can use that certificate to register the series to do business in other states and may thus preserve its limited liability. However, if the entity chooses to register under Delaware law, it can only get a certificate of good standing for the series LLC as a whole, and registering to do business in a non-series jurisdiction with that certificate could lead a court to treat the entire series LLC as a single entity for liability purposes.

Conclusion

The series LLC may well end up being a niche product, but for those who aren’t worried about ensuring they have limited liability in non-series states, forming a series LLC might be the least expensive way to structure a group of ventures in a way that preserves limited liability for each of them.

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When Should a Business Incorporate?

wolverine-blog

Although this is a complex question, thinking about it sooner rather than later may help the startup survive cofounder conflicts such as equity distribution disagreements. The reality is that founders should start to think about incorporating as soon as they have seriously considered starting a business on their own, or have a group of people that are starting the business with them. Many problems can arise at the early stages and incorporating may be able to help the startup get through them. Finding a good attorney can help founders navigate the maze of legal complexities and provide guidance through the tough conversations to come.

There is no clear answer as to when is the right time to incorporate, but there are some situations that indicate a business is ready for this step.

 

Is there more than one founder who is contributing intellectual property (IP) or could claim equity?

If so, then it is definitely time to incorporate. When the business incorporates, an independent legal entity is created. This provides some clarity when the question of who owns the IP comes up — assuming the employees have assigned their IP to the company. The line is clearer as to who owns the IP when the business has a separate legal entity than when there is no clear separation between the business and the founder.  You can read more about IP assignments here.

Finally, if there is more than one founder who could claim equity, then the business should be incorporated. Before any of the founders start to do substantial work for the business, especially in regards to technical or engineering work, it is imperative that the business incorporate. Otherwise, if there is any disagreement, then any of the founders could simply walk away with all of their work product without any legal repercussions. Also, in general, incorporating will make it easier to figure out who gets equity and how much.

 

Is one or more of the founders signing contracts or conducting business?

If the business is not incorporated, then the founders become personally liable if something goes wrong. When the business incorporates, it can sign contracts, borrow money and do things that a “person” could do. Because the business is a legal person, the creditors are generally only able to go after the business assets. This means that a founder’s personal assets are protected. In addition, incorporation, as mentioned above, will make it clearer to see who the business is at any point.

If one of the founders is signing the contracts, and later on, the business is incorporated into an entity such as an LLC or C-Corporation, then the founder may still be personally liable for these contracts. Because the corporation did not exist yet, it is not clear that the corporation was the one signing the contract.

 

Does the business have any employees? Are they getting paid with equity?

The business should be incorporated before employees are even hired, but if the business already has them, then it is imperative to incorporate immediately. This will make it easier to protect personal assets. An employer is responsible for any actions that the employee takes that is within the scope of the employment. Thus, if the employee makes a mistake or is negligent while conducting business, then the founder’s personal assets may be at risk — unless a business entity has been formed. In addition, it is easier to grant equity when the business is incorporated. Hence, if the founder is planning to grant equity as a form of payment, then it is time to form an appropriate business entity that meets those needs.

 

Is the business in need of investors?

Even if an investor is interested in supporting an entrepreneur, she may not be able to invest in the business if there is no legal entity to accept the investment. Furthermore, investors actually prefer certain types of legal entities and will not invest unless the company is incorporated as such. Investors want to make sure that their interests are protected; the structure of certain types of companies provide these protections.   

 

Is there a problem if the founders wait to incorporate?

Forgotten Founder: One of the biggest issues that may arise if the business does not incorporate at the right time is the forgotten founder problem. The forgotten founder is someone who is part of the business in the early stages of the venture, but drops out. After the company goes through financing or is starting to pay off, this person comes back into the picture. Usually, the forgotten founder claims he had a substantial role in the company’s success and demands some form of payment. Snapchat, like many other companies, had to address this situation.

Equity: For co-founders, determining how to distribute equity may be one of the most difficult hurdles to overcome. More than half of startups fail due to co-founder disagreements and equity distribution can certainly lead to serious disagreements. For example, after more and more time passes, one founder may start to think they are doing most of the work and deserve more equity than others. She may think this is obvious and does not address it with others. Then, when the conversation finally happens, she finds out that the her co-founders disagree. If the group cannot reach an agreement, then the founder may walk away, which could lead to the dissolution of the start up.

Incorporation forces the equity conversation to happen sooner rather than later. In order to formally incorporate, the co-founders must establish and define the roles of each member, as well as the equity each receives. This is important in order to protect the company’s interests if disagreements arise later on. In regards to the example above, if a co-founder thinks that she deserves more equity, the company has legal paperwork that is enforceable and spells out what was agreed. In addition, having these documents may be able to prevent misunderstandings.

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Hiring New Employees: Beware the Risks of Assignor Estoppel

Slinky!

A drawing included for the patent for a slinky (Patent #: US 2415012 A), issued in 1947.

Startup companies frequently hire new employees from established technology companies — or even competing startups. New employees often provide creative energy and technical expertise critical to the growth of a startup. However, new employees may also bring unforeseen liabilities as a consequence of their past employment. One such liability in the domain of patent law, called assignor estoppel, could prove hugely detrimental to a startup in potential patent disputes down the line.

 

Patent Basics

Patents provide their owners exclusive rights to exclude others from practicing the invention detailed in the patent. Patents can cover a huge swath of technology areas ranging from pharmaceuticals to software. The Patent Office has even issued a patent on a method of swinging a swing.

All patented inventions must have an inventor or a set of inventors, but the inventor can assign, or transfer, her rights to the patent to another person or entity. Most commonly, this occurs when an employee at a company invents something during the course of her employment. Many employers require employees to assign all of their intellectual property rights if the intellectual property connects to the employee’s work at the company. As patent applications have flourished in recent years, particularly in the field of software, many technology employees have pending or issued patents that are assigned to previous employers.

Once a patent has issued, patent owners can sue others who infringe the patented invention; these cases generally arise in federal district courts. Defendants battling against patent owners in these cases typically have two primary lines of defense: non-infringement and invalidity. Non-infringement means that the defendant did not actually practice the invention and thus did not violate any of the patent owner’s rights. Invalidity, on the other hand, means that the Patent Office should have never issued the allegedly infringed patent in the first place, because the patent did not satisfy the criteria necessary for a valid patent. Increasingly, district courts have been invalidating patents, particularly software patents deemed to cover un-patentable abstract ideas.

 

Assignor Estoppel

The rise of patent invalidations has rendered invalidity defenses invaluable weapons in defendant companies’ arsenals. But the doctrine of assignor estoppel can eliminate a company’s invalidity defense, potentially subjecting a company to millions of dollars in patent damages.

Assignor estoppel poses the following proposition: If an inventor files an application for a patent and assigns his patent rights to someone else, he cannot later claim that his assigned patent is invalid during a district court battle. Essentially, the doctrine prevents inventors from patenting an invention and later claiming that the patent is worthless.

For example, an inventor may create a new software application and then assign his patent rights to a large company in exchange for money. Later, the inventor may want to sell the software application to others, even though he assigned away his patent rights already. If he sells the application anyway and thus infringes the company’s patent, assignor estoppel will prevent him from trying to invalidate the patent if the company sues him.

This doctrine can also apply to the new employers of inventors as well. For instance, if the inventor in the previous example joined a new company (Company B) and helped that company develop a competing application, the original company with the patent rights (Company A) might sue Company B. During the ensuing district court battle, Company B may be prohibited from raising an invalidity defense because its new employee has infected his new employer with assignor estoppel.

Assignor estoppel will transfer from a new employee to his new company if a number of factors are met. Some of these factors include the employee’s leadership role at the new company, the employee’s role in allegedly infringing activities, and the employee’s ownership stake in the new company <http://www.ptabblog.law/?p=313>. Roughly, employees with larger influences at their new company pose a higher risk of infecting their new employer with assignor estoppel. At small startup companies, this risk can be significant and pervasive.

 

Nipping Assignor Estoppel in the Bud

So how can startups hedge their risk against a potentially “infectious” employee and secure the availability of legal defenses in patent suits should the need arise? Here are a few tips that entrepreneurs and startups should consider when hiring new employees or taking on additional founders:

  1. Have new founders and employees sign a form that assigns to the company all of the employee’s intellectual property rights that relate to the company’s business.
  2. Ask new founders or employees if they have any issued patents from when they worked at previous employers. Most companies require employees to assign their IP rights, but some employees may not remember that they assigned their patent rights to a previous employer. Consequently, you should search for any issued patents or published pending patent applications with the prospective employee’s name on them.
    1. If a prospective employee has issued patents or pending applications assigned to a competing company, ensure that your new products will not infringe or potentially infringe these patents. It may be prudent to enlist the services of a patent attorney to counsel the company on potential litigation risk relating to these patents.
    2. If the prospective employee will have a leadership role or ownership stake in the startup, the risks of assignor estoppel will be higher. If, however, the employee won’t be working on product development and receives no equity, the risks of assignor estoppel, while still potentially present, will be lower.

Hiring great employees involves a number of important considerations completely divorced from legal risks down the line. However, an employee’s prior patent assignments can create huge legal risks for burgeoning startups. Consequently, startups should be mindful of these risks when making hiring decisions.