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Economic Provisions within a Term Sheet

When startups attempt to raise funding for a priced round, founders are often primarily focused on the valuation of a term sheet. This focus is not entirely unfounded. A high valuation comes with an increase in working capital for the company’s growth. The founder is also given third-party confirmation of the value of the business they created. Still, for the long-term health of the company, as well as the entrepreneur’s financial well-being, it is crucial to look beyond the valuation to the terms that come with that dollar amount.

In evaluating a term sheet, entrepreneurs need to examine the other economic provisions that impact their wealth and the wealth distribution of other investors in the event of an exit. This blog post will discuss the impact of liquidation preferences, participation rights, and anti-dilution provisions contained in most VC offers. For a further anecdotal reading on the effects of provisions in term sheets, read: How To Build A Unicorn From Scratch—And Walk Away With Nothing.

 

Liquidation Preferences

While most associate liquidation to the failure of a company, a liquidation event within the context of a term sheet includes not just bankruptcy or a wind-down of the business, but mergers, acquisitions, or a sale of voting control. The liquidation preference refers to the multiple of the initial investment stockholders are entitled to receive for a liquidation event. For example, if Series A investors invest $2 million with a 2x liquidation preference, they would be entitled to 4 million for any liquidation event. The standard liquidation preference is 1x, so founders should critically examine term sheets with higher liquidation preference multiples.

 

Participation Rights

Liquidation preferences are combined with participation rights which have a significant impact on the amount founders receive in a liquidation event. Each series of investors have the right to convert to common stock. If the class of stock investors own is nonparticipating, then the investor must choose between their liquidation preference or converting to common stock. If the class grants participation rights, then investors may take their liquidation preference and convert their shares to common stock to receive the remainder of the proceeds on a pro-rata basis.

For a clear picture of how this works, let’s examine the Series A $2 million investment. Let’s say that the post-money valuation of the company is $6 million giving investors a third of the company. If the company is sold for $8 million, then investors with a 1x liquidation preference and no participation could either take the $2 million or convert to common stock. In this instance, they would convert to common stock as the $2.67 million return is higher than their liquidation preference. Now let’s examine a sale under the same fact pattern but with investors that have participation rights in addition to a 1x liquidation preference. Those investors would get their $2 million liquidation and then convert to common stock to get a third of the remainder which would be an additional $2 million. In this scenario, the investors would get half of the proceeds from the sale of the company despite only owning a third of the company. If a founder finds themselves in a position where they must accept a term sheet with participation rights, they should at least negotiate a cap on the multiple investors can receive in return.

 

Anti-dilution

Another critical economic term that founders should be cognizant of is anti-dilution. Anti-dilution provisions give investors the ability to protect themselves if a company later issues equity at a lower price than what they paid for in a previous round. There are two types of anti-dilution provisions, full-ratchet and weighted average. A full-ratchet anti-dilution provision can not only negatively impact founders but other classes of investors as well. Using the example of a Series A $2 million investment, if the share price is $5, then the Series A investors would own 400,000 shares. If the next round is a down round at $3/share, then a full-ratchet provision would give Series A investors shares at this lower price. So rather than 400,000 shares, these investors would have 666,666 shares, an increase of over 200,000 shares. Such a harsh term not only impacts payouts among classes of investors but the level of control within the company. This provision may also deter the next round of investors from providing financing in the first place.

A fair and more common solution would be to take the weighted average of the price of all shares outstanding. A weighted-average anti-dilution provision provides investors with the appropriate level of downside protection while also mitigating the dilution impact it would have on the founders and future investors.

 

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Why Outside Advisors are Critical For a Startup’s Growth and Success

Many startup founders of young companies fall into the same trap: they insulate themselves and just talk to family, friends, colleagues, and co-founders (if any) as a sounding board to bounce off business ideas and make decisions. While it’s easy to see why this approach is tempting, bringing on outside advisors early on who are not major investors or family members are integral part of a startup’s success.

A common way is to bring on outside advisors through an advisory board. A board of advisors is not a formal legal entity like a board of directors, which means that they can’t fire you or have control of your startup. Still, they can partake in regular board meetings as well as providing advice or mentoring on ad hoc basis. These are individuals who have certain knowledge that can be valuable to a startup. For one startup, that advisor may be a finance professor, a marketing expert, a software engineer, or an operations guru. For startups, advisors are generally compensated for their advice through stock or stock options in the company, although there can be other considerations for their time.

Notwithstanding the many benefits that come with onboarding a board of advisors, you should only bring them on if you are going to listen to their feedback. If you’re just looking to retain positive feedback while dismissing advice that potentially challenges your ideas, you’ll be wasting everyone’s time, including your own.

  1. Advisors will ask critical questions and challenge ideas: Consider the following scenario. You have a great business development idea and your co-founders and the team is pumped by the possibility. Who is tempering the enthusiasm? Who is there asking critical questions or challenging the business pipeline? If the answer to this is “no one besides the leadership team,” these ideas can become circular, unfeasible, and unchecked. Outside advisors who care about your idea can help sharpen your thought process and help fill the gaps in your business strategy. These are people who are willing to ask critical questions and offer complementary skills to the founders. This results in diversity of opinions.
  2. Advisors can help you build connections and relationships outside the entrepreneur world: Founders are often surrounded by other founders. Advisors have years of experience under their belt and in addition to providing an outside perspective, they can connect you to people outside your industry. For example, student-led startups can leverage their relationship with outside investors and meet experienced entrepreneurs, venture capitalists, and industry experts. Establishing common relationships through outside advisors will broaden your network.
  3. Startups need outside investors for future capital raising: Post angel investor and seed rounds, third party investors will look to see whether a startup has a few outside advisors, often in the form of an advisory board. If a startup has outside investors who have specific industry experience and seems invested in the company, it can serve as a market validation to potential investors. Further, outside investors can help you prepare for robust business milestones and successfully pitch to get more capital. They can also help you weigh in your funding options, evaluate growth plans, and carry your company forward.
  4. Advisory Board vs. Board of Directors: The board of directors is the central governing body for your startup. For small startups, founders serve as directors and don’t consider bringing in outside board members until the company took on significant investment. As previously discussed, the board of directors is legally bound to the business and therefore has a more serious engagement, because they carry potential liability associated with being part of that board. The board of directors has legally defined responsibility and is governed by the corporation’s bylaws; since directors are elected for established terms they are more difficult to remove. In contrast, a board of advisors can be more informal and flexible. It’s essentially a team of people appointed to guide and counsel founders and their startup. The board of advisors has no fiduciary duty to the company and because they carry less liability than directors, less compensation is required to retain an advisor.

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The U.S. Immigration System and a Workaround for Immigrant Entrepreneurs

An Overview of the U.S. Immigrant System

The United States has long been the country of choice for talented and ambitious immigrants. Immigrant entrepreneurs, in particular, are drawn to tech and entrepreneurial hubs such as Silicon Valley. There, celebrated tech visionaries such as Sergey Brin (born in Russia), Jerry Yang (born in Taiwan), and Elon Musk (born in South Africa) built iconic American companies such as Google, Yahoo, and Tesla, all of which have changed the way the world lives and works. Indeed, more than half of the country’s unicorn companies had at least one immigrant co-founder, and a quarter of engineering and technology startups had at least one key immigrant co-founder.

But to immigrate to the United States is not a simple matter. Under existing law, aspiring and established entrepreneurships can apply to one of several visa categories that would allow them to live and work in the United States. These include the following:

  • EB-1A Extraordinary Ability
  • EB-1C Multinational Manager/Executive
  • EB-2 National Interest Waiver
  • EB-5 Immigrant Investor Program

However, many of these visas are subject to strict caps and can come with strict requirements. The EB-1A visa for extraordinary ability, for example, can be granted to individuals to who have won prestigious awards such as Nobel Prize or an Olympic Medal or have made “original scientific, scholarly, artistic, athletic, or business-related contributions of major significant to the field.” The EB-5 Immigrant Investor Program, similarly, requires applicants to inject at least $500,000-$1 million in capital into the U.S. economy, with the expectation that their investment will create at least 10 qualifying full-time jobs.

Because these prerequisites would preclude most applicants, except for those who are already highly accomplished and successful in their chosen fields, most immigrants resort to the H-1B visa, a common but highly sought-after visa that is sponsored by companies for skilled labor. However, each year the cap of 85,000 visas (65,000 for individuals with job offers and an additional 20,000 for those with advanced degrees from U.S. universities) is filled within days of the application process opening. In addition, the Trump administration has increased the scrutiny applied to H1-B visa renewals and is planning to stop granting work permits to the spouses of H1-B visa holders.

 

Entrepreneurs-in-Residence

In response to these strictures, many have called for the creation of a “startup” visa, which would empower immigrant entrepreneurs to try and start their own businesses, rather than coming to the United States bound to the employer who sponsored their H1-B visa.

Until that happens though, the next best possible chance for immigrant entrepreneurs may be H1-B visas sponsored by universities through the H1-B program. Unlike company-sponsored H1-B visas, which are capped at 85,000, universities may sponsor an unlimited number of foreign-born entrepreneurs through what many are calling Entrepreneurs-in-Residence. The university technically employs the entrepreneur, who is required to complete a limited amount of mentoring, teaching, or advising. During their spare time, however, they are able to work on their own business ventures. One of these programs, GlobalEIR, currently works with seven universities to host entrepreneurs-in-residence, and to-date they have been able to secure visas for 42 entrepreneurs who have raised $29.9 million and hired 123 jobs.

The GlobalEIR program and others like them have now expanded to 14 university partners across six different states. Entrepreneurs interested in these visas should hurry to apply. Senator Chuck Grassley (R-Iowa) has recently taken notice of these programs and called them a “cynical exploitation of loopholes in the law,” which means that they may soon fall victim to the Trump administration’s attempts to reduce the number of immigrants allowed into the United States.

 

To learn more about some of the currently available programs, check out some of these sponsoring universities:

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Provisional Patent Applications Provide Lasting Intellectual Property Protection

A provisional utility patent application, as opposed to a non-provisional utility patent application, is not reviewed by a patent examiner at the United States Patent and Trademark Office (USPTO), and therefore will not directly lead to the grant of a patent. So, why do we care?

Often entrepreneurs launch their startups with a concept or a prototype of an innovative product. Their business goal is to commercialize the invention. Before the product is ready to be introduced to consumers or an interested acquirer, it has to go through a stage of commercial viability testing or technical improvements. During this period of time, startups face the dilemma of how to protect their intellectual property (IP) assets with limited capital and human resources. The decision whether to file a costly non-provisional patent application is complicated by uncertainty about the patentability of the invention, a patent’s added value to the startup and the commercial prospect of the product. Under this scenario, a provisional patent application is a sensible alternative providing benefits that a non-provisional patent application may or may not have.

Priority Date

Currently the US adopts a first-inventor-to-file system in regard to right to patent. Without patent protection, an invention is subject to the risk of being copied or claimed by another party. Available to utility and plant patents but not design patents, a provisional patent application can be used to establish the priority date of an invention, the same as a non-provisional patent application. The priority date is the earliest filing date of a patent application and used to determine the right of priority over an invention through prior art search and obviousness examination. If a non-provisional patent application is filed within one year after the filing of a provisional patent application, the non-provisional patent application can claim the benefit of the priority of the provisional patent application filing date. Startups may use the one-year grace period to research the market potential for or make further improvements to their product. In addition, startups may file multiple provisional patent applications and claim the priority dates of all of them in a single non-provisional patent application.

One requirement for the priority date claim is that the later filed non-provisional patent application must be adequately supported by the description in the provisional patent application. Also, a provisional patent application cannot claim the benefit of the priority date of another provisional or non-provisional patent application. On the other hand, the patent term of a utility or plant patent is based on the earliest filing date of a non-provisional patent application.

Patent Pending Status

The filing of a provisional patent application will allow startups to use the status label “patent pending” to describe their product, the same as a non-provisional patent application. The “patent pending” status not only will afford IP protection to the invention, but also may carry advantages in various business undertakings such as marketing, venture capital financing, valuation of the company, and deterrence of potential competitors.

Cost

The cost of filing a provisional patent application is much lower than that of a non-provisional patent application for several reasons. First, since a provisional patent application is not examined, it will not incur USPTO fees in prior art search, patent examination and communications. The basic filing fee is low. For example, the electronic filing fee of a provisional utility patent application for a small entity, such as a business organization with fewer than 500 employees, is only $70.

Secondly, the examination process of a non-provisional patent application usually entails back-and-forth communications between the USPTO and attorneys that could drag on for a couple of years and result in significant attorney fees. In total, the process of obtaining a patent may cost up in the tens of thousands of dollars. Finally, entrepreneurs will have to spend time and energy working with attorneys throughout the patent examination process. All of this may strain the capital and human resources of an early stage startup.

Scope of Disclosure

Different from a non-provisional patent application, a provisional patent application does not have to include any claims, which makes it simpler to write and easier to avoid the problem of narrow characterization. A claim defines the scope of protection and therefore tends to limit patent right to an invention. If the claims are written in overly narrow terms, competitors may be able to design around a patent making it unenforceable. Therefore, it is generally recommended to use broadening statements and alternative languages in patent application drafting.

A recent ruling, The Regents of the University of California (“UC”) vs. The Broad Institute (“Broad”), from the Patent Trial and Appeal Board (PTAB) of the USPTO illuminates the importance of the scope of disclosure in patent applications to an inventor’s right to patent. This dispute involves a genome-editing technique called CRISPR-Cas9. The CRISPR-Cas9 system, similar to a cut and paste tool in a word processor, may be employed to modify the genome of an organism by permanently deleting dysfunctional genes or inserting beneficial ones, thus holding enormous potential for applications such as developing therapeutics for intractable human diseases or pest-resistant plants.

In this case, UC’s non-provisional patent application, which was filed earlier than Broad’s and based on four provisional applications, described the CRISPR-Cas9 system in prokaryotes−single-cell organisms without cellular nucleus, such as bacterium, while Broad’s patents demonstrated CRISPR-Cas9 in eukaryotes−multicellular organisms such as humans, animals and plants. PTAB declared that the two parties claimed distinct subject matter in their disclosures. Given CRISPR-Cas9’s potential in changing the landscape of biomedical innovation and both parties of this dispute have established startups to commercialize the technology, the PTAB ruling was widely considered a huge win for Broad.

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Why Do Technology Startups Need IP Assignment Agreements?

If you are considering forming a startup, an intellectual property (IP) assignment agreement will be crucial for your company, especially if your company wants to get financing from outside investors in the future. An IP assignment agreement is a contract that transfers an individual’s rights to an intellectual property (for example, patent, trademark, copyright, etc.) to another legal entity, such as a company. You and your colleagues may want to ask: why do you need to transfer your intellectual property rights to your company?

 

What are the consequences for not having an IP assignment agreement?

If individual inventors do not assign the IP rights to the company, it will be very difficult for the company to seek investment in the future, because an investor will not fund a company that does not have the complete ownership of its intellectual property assets. Therefore, the IP assignment agreement will be a key document that the investor will look for before deciding whether she will fund the company.

Imagine two inventors jointly own a patent. An obvious concern for potential investors is whether this patent can be effectively protected against infringement. However, if the patent is involved in patent infringement litigation, both co-owners must join the lawsuit so that the suit can be filed. Either owner’s lack of interest in joining the litigation will make the patent meaningless because the patent can be easily infringed. In contrast, if a sole owner, the company, owns the patent, the company itself can bring this suit. This is easier for protecting the patent because the company does not need to get every owner’s consent to bring the suit.

Additionally, the value of the patent will be diluted if it is jointly owned by several owners. Each co-owner of the patent can independently exploit, without consent of, and without accounting to, the other co-owners. Because a license is available from more than one party, its value is inevitably diluted. Otherwise, if a potential licensee wants to get an exclusive right to the patent, it must negotiate with all owners, and the holdout problem (where one party’s withholding of support prevents a deal) is likely to occur.

 

What provisions need to be included in an IP assignment agreement?

Because the IP assignment agreement is critical to a company, the agreement should be drafted by a lawyer. Both the Assignor (e.g., the individual developer) and the Assignee (e.g., the company) must carefully review the provisions in this agreement. The most important sections of an IP assignment agreement are:

Assignment of Intellectual Property. This section describes the assignment and acceptance of the intellectual property. If the Assignor agrees to assign the intellectual property in exchange for a consideration, either in the form of cash, equity or royalty, the consideration needs to be clearly identified in the agreement.

Description of the Assigned Intellectual Property. The agreement usually includes a full description of the intellectual property or refers to an exhibit that describes the intellectual property. Notably, the to-be-assigned intellectual property sometimes includes goodwill, which is the intangible value of the intellectual property. The assignment of trademark’s goodwill is particularly important because it includes the brand’s reputation and recognizability.

Warranty. It is especially important to have the Assignor warrant that she has the capacity to assign the intellectual property. Otherwise, the assignment may not be effective.

An IP assignment agreement is crucial for showing your startup’s future investors that the company possesses valuable intellectual properties. Therefore, soon after your company is formed, remember to ask everyone who may have a right in the intellectual property, including inventors, employees, independent contractors and so on, to sign the IP assignment agreement.

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Forming an LLC: Member-Managed or Manager-Managed?

After considering advantages and disadvantages of different forms of an entity, you have now decided that forming an LLC (limited liability company) would be the best option for your company. However, you have to go through one more step to be completely done with the entity selection process: Should you form a member-managed or manager-managed LLC?

Basically, you may choose one of two different management structures for an LLC: Member-managed vs. Manager-managed. Member means an owner of an LLC in this context. In Michigan, the default management structure of an LLC is member-managed, as is the case in most other states. However, you may choose to form a manager-managed LLC instead by designating it in the Operating Agreement.

 

Member-managed vs. Manager-managed LLCs

Member-managed LLCs:

If you choose to form a member-managed LLC, all members have an equal right to participate in managing and operating the company unless the operating agreement states otherwise. A member-managed LLC essentially leaves no room for outsiders to jump in and interfere. Consequently, a member-managed LLC allows every member to vote in the decision-making process and enter into binding agreements and contracts on behalf of the company as its agent. However, members may choose to form an LLC with different classes of members where one class would have a different level of rights than the other classes. Also, the operating agreement can limit the scope of authority that each member has in a member-managed LLC. For instance, the operating agreement may require a majority or unanimous vote of members to make certain business decisions such as contracts and loan agreements.

Member-managed LLCs also do not have boards of directors unlike manager-managed LLCs. Also, member-managed LLCs tend to be more cost-effective than manager-managed LLCs due to their decentralized management structure.

Therefore, a member-managed LLC could be a better option for you if every member of your company wants to play an active role in running the business. However, a member-managed LLC also has some downsides due to its management structure: 1) it might be inefficient if the company is too large or complicated for all members to take a part in managing and operating the business; 2) it can also turn out to be inefficient if some members are not well-versed in business management; and 3) the expulsion of a member could be difficult since it would require an unanimous approval of all the other members unless specified otherwise in the operating agreement.

 

Manager-managed LLCs:

On the other hand, manager-managed LLCs have one or more managers to manage the company and arrange business affairs on the company’s behalf without getting the members’ consent or approval first. Only designated managers have the authority to make determinations on behalf of the LLC in manager-managed LLCs. Thus, manager-managed LLCs have a more centralized management structure and enable the company to be managed more like a corporation. For this reason, manager-managed LLCs would be preferable if your company is large and complex, since getting all the members together to vote and make decisions as a whole could be inefficient for large companies. Hence, a manager-managed LLCs would streamline the decision-making process and enable members to focus more on works of their choice in such cases.

Members may select one or more of the members as managers of the LLC, or they may hire professional managers who are not members of the LLC but have adequate expertise and qualifications. Having professional managers with experiences in business management can also be beneficial for your business in terms of protecting the company’s interest, attracting investors, and protecting the investors’ money. The members may specify details such as the number of managers, required qualifications, and resignation procedure in the operating agreement.

Since manager-managed LLCs allow managers to make decisions on behalf of the LLC without acquiring members’ consent first, this management structure would be more suitable if members of your company wish to take a more passive role. For instance, if some members of your company are investors and do not want to get involved in day-to-day management of the company, manager-managed LLC could be a better option for your company. If members of your company wish to select some of the members as managers, it would be advisable to designate more active members as the company’s managers. Members who are designated as managers may also receive a separate compensation as an employee.

 

Fiduciary Duties

Members of a manager-managed LLC as well as managers of a manager-managed LLC, including both professional managers and members who have been designated as managers, owe fiduciary duties to the LLC. In Michigan, a person who manages an LLC does not owe fiduciary duties to the members of the company. Fiduciary duties mean duties of trust that mandate people who owe such duties to place the company’s interests above their own or other parties’ interests. However, the members may agree to waive some fiduciary duties by specifying that in the operating agreement.

The two most important types of fiduciary duties owed to an LLC are 1) the duty of loyalty and 2) the duty of care. A person who owes the duty of loyalty to an LLC is expected to place the company’s interests above his or her personal interests and goals. He/she also needs to conduct any transactions and deals on behalf of the company in good faith. Also, he/she must not compete directly with the company or take advantage of the company’s internal information, commercial activities or business opportunities in an inappropriate manner to earn secret profits.

On the other hand, the duty of care requires one to act prudently in good faith and exercise reasonable care when performing their work on behalf of the company. If a member of a member-managed LLC or a manager of a manager-managed LLC makes a business decision with negative consequences for the company, that person would be protected from liability as long as he/she made the decision in good faith and exercise reasonable care during the process.

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The Defend Trade Secrets Act & Startups

President Obama signed the Defend Trade Secrets Act (the “DTSA”) into law on May 11, 2016, and established the first federal cause of action for trade secret theft. The DTSA provides protection of trade secrets by enabling companies to bring suit in federal courts without needing diversity jurisdiction, as well as by providing a mechanism through which plaintiffs can retrieve stolen trade secrets. Startups often heavily employ trade secrets and other intellectual property, so they should take particular care to familiarize themselves with the provisions of the DTSA.

 

What the DTSA Does

To be clear, the DTSA does not substitute for or alter the trade secret laws already in place at the state level. It allows companies to bring trade secret suits in federal courts more easily than before, as diversity is no longer needed between the parties. This can become a bargaining chip for companies who want to resolve disputes more quickly with defendants who would prefer not to go to trial in federal court.

The DTSA also provides ex parte seizure of allegedly stolen trade secrets, where the company can retrieve the stolen property without any notice to the alleged trade secret thief. Because this is an extraordinary measure, the companies (the plaintiffs) must meet a high bar and show extraordinary circumstances for the court to grant ex parte seizure. This mechanism allows startups to quickly halt dissemination of trade secrets when an employee leaves for another company, and begins using the trade secrets she acquired from her original company at her new one. Startups are particularly susceptible to trade secret breaches, as employee turnover or poaching tends to be higher than in more established companies or industries. For instance, in Mission Capital Advisors LLC v. Romaka, the court ordered the seizure of contact lists and other electronically-stored information that was allegedly stolen by a former employee of the plaintiff company. The data-driven modern era enables employees to steal huge amounts of data with little effort, so the DTSA provides one welcome method with which to reign in trade secret theft.

The DTSA also provides whistleblowers with immunity when they disclose trade secrets to government or law officials, as long as they do so in relation to furthering an investigation or a lawsuit.

 

The Notice Requirement

The DTSA requires employers to include a notice of whistleblower immunity in all of its contracts with employees, contractors, or consultants if the contracts restrict the use or disclosure of trade secrets. As noted above, this provides protections to whistleblowers who reveal trade secrets to federal, state, or local government officials when the whistleblowers are assisting in investigations or lawsuits.

All startups that possess and deal with trade secrets should include these notices in their contracts with employees, in order to comply with the DTSA. It may also be helpful for startups to provide training for their employees regarding the companies’ trade secret policies, as well as on federal and state trade secret laws.

 

The DTSA Descriptions of Trade Secrets

One potential roadblock for plaintiffs in DTSA claims is the extent with which to identify the trade secret alleged to have been stolen. The court in Mission Measurement Corp. v. Blackbaud, Inc. articulates this issue, noting that trade secret allegations, if too detailed, may constitute an “unwitting disclosure of the trade secret to the public.” In its complaint, Mission Measurement described the allegedly stolen trade secret broadly as a software program, and identified it with dates of its use and agreements or meetings made in relation to it. The Defendants argued that the allegations lacked sufficient particularity and were thereby inadequate, because the complaint failed to identify with enough specificity the trade secrets at issue in the lawsuit. The court rejected this argument, and concluded that “such allegations were adequate in instances where the information and the efforts to maintain its confidentiality are described in general terms. The court in Aggreko, LLC v. Barreto clarifies this notion, ruling that allegations of trade secret theft must still describe the trade secrets to the extent the defense “would be put on notice as to the nature of the claim.”

When bringing DTSA claims, startups should therefore be mindful to maintain the confidentiality of their trade secrets by not revealing too much in their complaint, but to also plead with enough detail so defendants cannot reasonably argue that they cannot pinpoint the specific trade secrets that were allegedly stolen.

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How to Split Up Equity Among Co-Founders (and Why You Should Care)

You started a company with a couple of your good friends. Some have put in more money or time than others, but you feel like you can trust each other. That’s why when it’s time to formalize the business and raise money, you all come to the non-confrontational answer of how to split up the equity: equal ownership for everyone. It’s simple, seems fair, and avoids any awkward debates. But does it really make sense?

The answer is likely to be “no”, although it’s what many startups do. While splitting equity evenly is a good way to avoid an awkward discussion today, it may set you up for failure further down the road — when the stakes are higher.

 

The Dangers of Splitting Up Equity Equally

Prospective investors will be skeptical when they hear that there’s an even-split. They will want the equity split to determine each team member’s level of contributions and commitment. If the split doesn’t match the respective contributions and commitment, the team is not going to be incentivized appropriately to get the job done. Investors are especially wary of uncommitted founders that try to exert a disproportionate influence but don’t meaningfully contribute to the startup’s success.

It may reflect upon the team’s ability to run an effective startup, as well. Investors may be inclined to think the founders are not sophisticated enough to know what type and level of contribution it will take by each member, based on his or her role, to grow the business. Worse, they may just write off the startup as being unprepared to discuss the question of equity, chalking it up to the founders being hesitant to tackle tough issues.

At the very least, if you’ve decided to go with an even-steven split, you should be prepared to explain your reasoning (read on for guidance on that).

The other reason the split should be more thoughtful is more obvious: things can (and will) change. Your co-founders may already have insight into their respective future commitments and how much effort they can realistically put into the startup’s success. The startup may require more work than one of the co-founders wants to put in, leading them to tap out early. At that point, a tense conversation may ensue and it will likely be harder to change the split – leading to legal headaches, tax issues, and strained relationships.

 

How to Split Up Equity

There’s no one magic formula to get this right. The best strategy is to have an honest discussion up front about what each of you bring to the table. The evaluation should cover the following:

  1. Experience

Equity splits should take into account background experience relevant to the startup that will be essential to its success going forward. Also, more senior members may have a larger founders’ equity percentage than more junior co-founders, since they’ve put in more time before others joined at later stages. This leads us to….

  1. Sweat Equity

In return for helping to start the company, co-founders might forgo salary early on to earn an additional share of “sweat” equity. The split should reflect how much time and effort a co-founder has (and will) put in, and what the monetary value of that effort looks like relative to other team members.

  1. Capital Investment

Founders may have put in capital to fund the startup. Those who put in more than others may be compensated by receiving a larger portion of founders’ common equity as a result, rather than structuring their investment as debt or some type of separate investment instrument, like preferred equity (making them akin to venture capital investors). This factor should be closely assessed with future commitment to the company.

  1. Future Commitment / Role

The equity split should reflect the on-going involvement of the co-founders in the company. One or more of the co-founders won’t be involved on a full-time basis going forward. Those co-founders that are there for the long haul and working full-time should have a multiple-times larger chunk of equity.

Note that earning equity as a co-founder should always be contingent upon staying with the company for a certain amount of time – called a vesting period – typically four years. This incentivizes co-founders to stay on and build out the startup. If they depart early, they’ll only get whatever equity they have earned up until that time

  1. Role in Ideation

The ones who came up with the idea and / or created the IP behind the startup may request more equity. However, it may be wiser to value execution of the business over the initial idea. That’s why we recommend focusing more on sweat equity and future commitment; that being said, most discussions will involve how to make sure the person who came up with the idea gets a fair share.

It’s OK to split up equity evenly – so long as there is sound reasoning behind doing so. It’s not necessarily one of the first decisions you must make, although earlier is better. If you still need time to figure out how the above criteria will pan out, think about putting a stake in the ground with a rough estimate of equity splits (or even equal split), but also set aside an equity “pool” (say, 25%) to allocate down the road if things change or to correct an inequity that might happen should one of the founders underperform or excel beyond the others.

More resources

  • Check out this piece at Quartz on the Slicing Pie model for splitting equity
  • Consider the equity calculators on Gust and Foundrs.com, or the spreadsheet from Founder Institute. These tools help you determine how to split up equity based on several factors (commitment, ideation, pay, etc.)
  • The Zell Lurie Institute at the University of Michigan Ross School of Business has experienced faculty and staff members who can help if you’re a student entrepreneur. You can request an appointment to speak to a representative here.

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Should SAFEs replace Convertible Notes?

You may have heard about the investment instrument Simple Agreement for Future Equity, otherwise known as a SAFE. SAFEs are just one of the many things Y Combinator is famous for. Y Combinator released their form documents for this instrument in late 2013, so they have been around for some time now. However, the startup community remains divided as far as whether this kind of financing is beneficial to entrepreneurs and investors alike.

SAFEs are investment instruments that represent a promise between the company and the investor. The investor hands the company cash in exchange for the promise of the company to issue stock to the investor when some agreed upon triggering event takes place. Typically, this triggering event is when the company experiences a subsequent priced round, but the triggering event can be any one of many events the company believes it will go through. Although this process sounds similar to that of a convertible note, SAFEs are not debt instruments. They do not have a maturity date, they do not collect interest, and they are not subject to some of the regulations imposed on convertible notes. Unlike convertible notes, SAFEs have some unique features.

 

Flexibility

One of the most attractive things about SAFEs is the range of options available to the investor and entrepreneur in negotiating the terms of the SAFE. Convertible notes come with red tape and many different terms to agree on. However, SAFE negotiations usually center on one term — the valuation cap. Since there is generally only one term to negotiate, it’s “safe” to assume that the amount of time and money the investor and entrepreneur must dedicate and spend on negotiations will be lower than a convertible note. Thus, allowing for some of that precious capital to be spent on what really matters – growing the business.

 

Timing

SAFEs not only can be used as a mechanism for seed capital, but the instrument can also be used, under the right circumstances, to help an early stage company with a significant short-term expense.

 

Not Debt; Therefore No Interest

Convertible notes come with a string of terms to negotiate such as conversion cap, discount, conversion on maturity, the sale of the company, and much more. SAFEs on the other hand typically only require negotiation of the valuation cap – the cap sets the highest value that may be used to determine the conversion price of the SAFE. Another important distinction is that SAFEs do not have a maturity date like convertible notes. If the company takes years to receive new funding, the SAFE owner still maintains their right to conversion. If the company goes public, has a change in control, or dissolves the SAFE holder still maintains their right to conversion. In each of those scenarios, the SAFE is designed to convert. However, it’s important to keep in mind these conversion terms are all negotiable.

It’s important to remember that SAFEs may not be suitable for all situations and that there are drawbacks to using a SAFE. SAFEs have the potential to dilute the founder’s ownership share in their own company, causing the founder not to be properly incentivized. Having too many SAFEs on the company’s capitalization table may cause future VCs to shy away from investing in the enterprise due to them having to be pressured to a higher valuation than they may want to give. Entrepreneurs often assume the valuation cap on the SAFE will become the floor for the future equity round, as well, which is not always the case.

Overall, the entrepreneur will want to evaluate their company’s particular position when deciding whether to use a SAFE or convertible note during the seed and later rounds. It’s important for the company to assess their situation, analyze the pros and cons of issuing a SAFE versus a convertible note, and to ask if the issuance of a SAFE aligns with the company’s long-term goals.

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How to Strengthen your Chances of Registering a Trademark

When you see two golden arches that form the letter “m”, your mind probably jumps to McDonalds. That world-famous logo was successfully registered as a trademark, and has served as a way for consumers to recognize the source of the product ever since.

Registering a trademark has many advantages. Registration can discourage other companies from using a similar mark, because the registration makes it easily searchable to the public, in effect deterring them. In addition, future applications of similar marks will be refused registration, as the United States Patent and Trademark Office (USPTO) is required to cite existing registrations against new applications. In the event of trademark infringement, the registered trademark holder has the ability to sue for damages.

The application process to register a trademark can be difficult to navigate, but there are a few steps an applicant can take to make it smoother and more likely to result in a registration. If there are registration-barring problems within an application, a trademark examiner employed by the USPTO will respond to the applicant by issuing an “Office action”. Office actions detail exactly what about the application prevents it from being registrable. Often, the reason for rejection is the genericness or descriptiveness of the mark.

Trademarks are categorized by their ability to identify a source, on a scale of distinctiveness. The four classifications of distinctiveness are: 1. Arbitrary or fanciful, 2. Suggestive, 3. Descriptive, and 4. Generic (in descending order). The more distinct a trademark is, the more likely it is to be registered. Beginning from least distinctive, a generic mark is one that obviously describes whatever the product itself is. For example, if the product was a table, a generic mark for the product would also be “table”. Trademark law does not permit generic marks to be registered, and they can never be distinctive.

A step up from generic marks are descriptive marks. These require only a little bit of imagination from the general public to figure out what the product is. An example of this would be “Sweet and Salty” to describe a trail mix with sweet and salty components. Descriptive marks only meet the registrable standard of distinct if they have acquired secondary meaning. Secondary meaning refers to when consumers recognize the mark as the source indicator. Examples of descriptive marks which have acquired secondary meaning are “Windows” and “Sharp”.

Suggestive marks are inherently distinctive, and can be registered as trademarks. They require the public to make some imaginative leap between the mark and the advertised product. Examples of famous suggestive marks are “Playboy” and “Coppertone”. Finally, there are arbitrary or fanciful marks. These are inherently distinctive as well, and have the strongest chance at being registered. Arbitrary or fanciful marks give the consumer no obvious relationship between the mark and the product. “Kodak” and “Apple” are examples of arbitrary and fanciful marks that have been successfully registered.

In accordance with these categories, an applicant has a greater chance of being successfully registered if the mark is strong, requiring more imagination from consumers to determine what the product is.

Another way to minimize road blocks in the trademark registration process is to start using the mark in commerce as soon as possible. If the mark is already in use, then the application process becomes a bit easier. If the applicant must apply under an “intent to use” rather than a “use in commerce”, they must wait to be officially registered before they can submit a Statement of Use. In addition to that, it is helpful for an applicant to have a specimen of their trademark ready for the application.

A specimen of a trademark shows the USPTO how your trademark has been used in commerce. For standard trademarks in connection with goods, a specimen cannot merely be a drawing or mark-up of the trademark. It must be a real-life sample of how it is used on the goods in commerce. Office actions that are refusals issued on grounds of the lack of a proper specimen, an applicant may overcome responding by submitting a specimen, changing the basis of the application to “intent to use” rather than “use in commerce”, submitting a verification of the specimen, submitting evidence that the specimen was used with the goods, or submitting an unaltered, legible copy of the originally submitted specimen. Of course, submitting a proper specimen at the outset is the best way to avoid this extra hurdle.

Finally, the simplest way to ensure a clean application process is to submit a thorough and accurate application. Applicants may want to first print out a PDF version of the application and make sure they have all the fields accurately filled out and answered before trying to register their mark on the UPSTO website just to be sure to catch any oversights before the examining attorney does. Some fields to pay attention to are the correct classification of the goods or services, the submission of a specimen, or the adding of any disclaimers for the mark.

These three steps: choosing a strong mark, having a valid specimen available, and carefully answering the questions on a trademark application, are all simple ways to reduce the number of Office actions the USPTO must issue before the trademark can be properly registered. With these techniques, applicants can be well on their way to registering a trademark to officially protect their brand.