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Employee Arbitration Clauses and Protecting Your Startup in an Uncertain Legal Landscape

Many in the general workforce see working for a startup company or newly founded venture as a “hot” career move, sitting at their desks pondering such a move as they work for large, traditional companies with structure akin to your everyday Fortune 500 company. Making the switch to a startup often comes with the excitement of building a business, the freedom and culture associated with the workplace or simply the feeling of becoming part of something “larger” than yourself. However, there are also great risks an employee takes when pursuing such a career move.

 

The Issue 

In many cases, startups lack the ability to comply with a vast number of legal regulations, commonly in the labor and employment area. Employees might lose the feeling of security on matters that are normally handled by large HR departments within a large, established company. For example, where an HR department might handle the calculation of how much overtime pay a given employee is owed, a task like this might slip through the cracks at a startup in which creating a minimum viable product is the focus.

Currently, worker classification issues are plaguing startup companies like Uber and WeWork on matters ranging from underpaying employees to simply not providing statutorily mandated benefits. Some early-stage startups view noncompliance with labor and employment regulations as a small issue when compared to the hurdles that must be overcome to get a business up and running, but these seemingly small issues can destroy a company at later stages due to costly liabilities for workplace disputes and employee lawsuits.

 

The Possible Solution

In response, many startups turn to what they hope is a safeguard against large-scale employer liability for labor issues: employee arbitration clauses that bar collective or class-action suits. One New York Times headline from 2016 reads, “Start-Ups Embrace Arbitration to Settle Workplace Disputes”; from a general survey of the start-up scene, the Times is spot on. Early-stage companies are increasingly including arbitration clauses in their employment agreements that bar employees from taking collective action against their employer in a civil court, instead forcing individual arbitration requirements. From an employer’s perspective, this removes the incentive that employees normally have to bring disputes to arbitration or civil court in the first place because the cost of doing so individually likely outweighs whatever damages an employee may be awarded for back pay or improper benefit plans. However, employees may resist these clauses, and they may attract unwelcome press attention.

So, if employee arbitration clauses banning class action disputes provide some protection to startups, why are we even talking about this? As happens with many contractual devices providing corporations and employers with an advantage in a bargaining context, a number of plaintiffs launched legal challenges to the overall validity of employee arbitration clauses that bar class action suits. In January of 2017, the Supreme Court decided to consider a group of related cases concerning whether arbitration agreements containing class action waivers violate employee rights under the National Labor Relations Act (NLRA) in order to resolve a federal circuit split on the issue. Thus, come Fall 2017, that tool for protecting your startup from large-scale liability might be removed from your toolbox altogether.

Why might the Supreme Court find these class action waivers are invalid?

  • The NLRA, a federal statute applicable in all states, protects employees’ rights to engage in “concerted activity” to improve wages or working conditions
  • The National Labor Relations Board, responsible for enforcing the NLRA, has issued decisions that hold agreements between employers and employees to handle disputes exclusively on an individual basis violates employee’s rights to engage in “concerted activity”

What does this mean for your startup?

  • Until the Supreme Court hands down a decision on this issue, arbitration clauses with employee class action waivers may still be considered enforceable from a legal perspective, depending on where the company is located
  • Regardless of the Supreme Court’s decision, the best way to avoid liability for labor disputes remains complying with the applicable labor laws and regulations whenever and wherever possible
  • If the Supreme Court rules that these waivers are unenforceable, it becomes even more important to comply with applicable labor laws and regulations because large-scale liability for employee disputes is far more likely if collective action is available
  • If the Supreme Court rules that these waivers are enforceable, the status quo remains, but it only means that the likelihood of facing large-scale liability in employee disputes is lower than it would otherwise be

What should you do from here?

  • Review current employment agreements and evaluate whether or not any provisions in the agreement might constitute an employee waiver to class action disputes (e.g., binding arbitration clauses)
  • Consult an attorney who is familiar with labor and employment law and inquire about ways to mitigate risk in this area
  • If the Supreme Court rules these waivers are unenforceable, remove such terms from your employment agreements for clarity and to avoid disputes concerning the validity of the other terms in an employment agreement
  • If the Supreme Court rules these waivers are enforceable, consider using them when drafting current and future employment agreements in order to protect your business from large-scale liability

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Employer-Employee Relationship Matters in Patent Ownership

When an employee creates an invention and later is issued a patent on that invention, does the employer get any rights to the patent? This might be a strange question to ask for some people, especially to those without expertise on patent law. They might take it for granted that an inventor owns all patent rights to his or her invention. However, this is not always the case.

 

Patent Law: Ownership is Different From Inventorship

A person must show that he or she contributed to the claims of a patentable invention in order to qualify as an inventor of the patent. By default, the inventor becomes the owner of the patent, but this ownership can be assigned away through a written document, or in some instances through an implied-in-fact understanding (discussed below).

It is the owner, not the inventor, who enjoys all property rights to the patent. With these property rights, the owner of a patent can license the patent to third-parties; sell the patent ownership; sue a potential infringer; and manufacture, offer to sell, sell, or use a product covered by the patent. If the inventor assigns his ownership to someone else, then he or she will not have any of these rights.

 

Ownership and Inventorship in Employer-Employee Relationship

The general rule is that the employee who creates an invention owns the patent rights to the invention. There are two exceptions to this general rule: (1) intellectual property (IP) was explicitly assigned to the employer or (2) the employee was specifically hired to create the invention at issue.

Explicit assignment of IP usually occurs in the form of signing an IP Assignment Agreement. The agreement would provide that all IP that the employee has created or may create in connection with the services provided to the company and/or derived from the company’s proprietary information shall be the property of the company. Different states have different laws regarding the scope of work that this assignment can cover. For example, California’s labor law stipulates that an employee owns the patent rights to his or her invention if the invention is made entirely on the employee’s own time, without using any of the company’s equipment or technology, as long as the invention (a) does not related to the company’s business, and (b) did not result from work performed by the employee “as an employee” of the company.

Even if an agreement was not signed between the employee and the employer, the employer might still have been assigned the patent rights if the employer explicitly hired an employee to invent the product that was patented. This arises from the implied-in-fact understanding that the employee was specifically hired and paid to create the invention and therefore, any fruition of patenting the invention should be the employer’s.

 

Where Assignment Has Not Been Made, Employer Might Still Have “Shop Right”

So is the employer completely without any remedy if the assignment scenarios above do not apply? Not if the employee used the employer’s resources, such as its computers or laboratories, to create the invention. A judge-made doctrine called a “shop right” allows employers to practice inventions created by employees that the employer helped to subsidize.

However, a shop right does not involve transfer of ownership. A shop right is basically a non-exclusive and royalty free license given to the employer. The employee still holds the ownership of the patent and is free to go to third parties and negotiate non-exclusive licenses. Also, the employer cannot sell or transfer this shop right to a third-party.

One important note: the shop right doctrine is not a substitute for an assignment. The doctrine is only a defense to patent infringement in court. In other words, it only arises in situations where the employer is sued by the employee for infringing the patent that the employee was issued by practicing the invention.

 

Implications for University Students and Faculty

Many startups are formed by the students and faculty of universities. Graduate students and faculty typically sign an IP assignment agreement with the university, which means that the employer-employee relationship discussed above is established. A good example of this relationship is Larry Page, one of the co-founders of Google, and Stanford University. As you can see from the excerpt of patent number US 6,285,999 below, the inventor of this patent that served as the foundation of Google was Larry Page. However, he was not the owner of the patent because he was a Ph. D. student at Stanford. As a result, the assignee of ownership was Stanford University, and the university received 1.8 million shares of Google stock in exchange for long-term license of this patent, which translated to $ 337 million.

Meanwhile, each university has its own policy regarding IP assignment of undergraduate students and other students who are not employees, but typically, universities do not seek to claim rights to patents issued as results of class participation. For example, the University of Michigan policy states that:

“The University will not generally claim ownership of Intellectual Property created by students. (A “student” is a person enrolled in University courses for credit except when that person is an Employee.) However, the University does claim ownership of Intellectual Property created by students in their capacity as Employees. Such students shall be considered to be Employees for the purposes of this Policy. Students and others may, if agreeable to the student and Tech Transfer, assign their Intellectual Property rights to the University in consideration for being treated as an Employee Inventor under this Policy.”

 

Advice for Startups

If you’re a startup, there are many other issues regarding IP that should concern you. Regarding the employee IP assignment issue, make sure that all employees sign IP assignment agreements. Litigation is expensive. You don’t want to go to a court to argue that you had an implied-in-fact assignment or that you have a shop right defense to infringement. IP assignment agreements are a lot easier.

Also, find out whether you are working with university faculty or grad students already in an employment relationship with a university. This pertains to your employees as well as independent contractors who will participate in creating inventions for the company. Your employee or independent contractor signing multiple IP assignment agreements could cause ownership problems further down the line.

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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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Rethinking Worker Classification in the Emerging On-Demand Economy

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Classifying workers may raise fundamental questions for on-demand economy startups.

The emerging on-demand and sharing economy has presented no shortage of legal issues for tech startups.  One of the key factors underlying the success and future of these companies lies in the way they harness and classify their workforce. Startups entering this space must be aware of the developments in employment law because worker misclassification can have drastic financial consequences on their business.  So critical is the classification of workers as independent contractors to the on-demand economy that many of these business models would crumble under an employee (as opposed to independent contractor) worker classification schema.

And there is no dispute that the class action litigators are gunning for companies whose cost structure relies on the 1099 workforce.  The pending Uber cases provide prime examples of this issue in the on-demand economy, but misclassification cases are by no means restricted to companies operating in this space. Starbucks, FedEx, Lyft, Homejoy, Postmates, and Caviar are all companies that have been on the receiving end of these attacks.

The Uber Class Action Lawsuits

Uber has been under legal fire for class action lawsuits filed by their drivers accusing the company of misclassifying them as independent contractors rather than employees.  Among other things, these workers claim that their services are central to Uber’s business and that Uber has the requisite level of control over them to place them in the employee bracket. We covered key factors that courts and the IRS consider in a previous post.  In essence, the drivers claim that they are Uber employees even though they benefit from a work environment that allows them complete flexibility of scheduling, no minimum required hours, and the freedom to work for competitors of Uber.  Ultimately, the drivers and their advocates want better protection and compensation packages for these workers, benefits that are typically reserved for employees as opposed to freelance independent contractors.

In response, Uber has asserted that there is no such thing as a single type of Uber driver.  All sorts of people are drawn to working for the company due to its flexible scheduling and the manner in which drivers can perform the services.  Uber continues to maintain that its core business is a platform that allows these drivers to use it as they wish.

But in 2015, U.S. District Judge Edward Chen stated in court that “The idea that Uber is simply a software platform, I don’t find that a very persuasive argument.”  It is not enough for a company merely to assert that they are a logistics company or a software platform to retain the benefits of a 1099 workforce. These cases will set significant precedent with regard to worker classification for companies operating in the on-demand economy.  Jury trial for the California Uber class action lawsuit is scheduled to commence in June 2016.

Consequences of Worker Misclassification

In a previous post, we also discussed strategies for defining the employer-worker relationship and avoiding worker misclassification.  But how much of a problem can worker misclassification really cause?  The short answer is that the ramifications can be substantial.  Companies may be liable for thousands, millions, or billions of dollars (if you’re Uber) in back wages and taxes, fines, penalties, insurance contributions, and workers compensation costs.  And it is important to remember that the company’s intentions regarding the misclassification are irrelevant – intentional or not, you’re still on the hook for misclassification damages.

The Proposed Third Category of Worker or a Revised Test

The sharing economy is powered by so-called “micro-entrepreneurs,” workers who want the flexibility of scheduling and use of personal resources to earn what they need when they want.  According to peers, the “future of work will include a portfolio of income streams” that enables workers to have the choice to “build their work around their life, not their life around their work.”  Arguably, it is a different breed of worker that calls for the jobs provided by companies operating in the on-demand economy.  But they cannot have it all.  And this goes for both sides of the coin – employers and workers alike.

If workers for companies such as Uber are classified as employees rather than independent contractors, the added costs might run the company into the ground, or at least cause it to raise its fares.  This is an undesirable situation for everyone, calling for new solutions in the field of employment law.  One such solution is the proposed third category of worker, the “dependent contractor.”  Under this category, dependent contractors would gain some (but not all) of the protections or benefits afforded to employees while retaining the flexibility and control over their work.  Similarly, it seems clear that the current standards used to evaluate worker classification need to be revised to address the features and needs of on-demand workers and companies operating in this sector.

It is difficult to imagine the crash of the on-demand economy, but only time will tell as to how these companies evolve in response to worker classification issues.

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Avoiding Misclassification – Employee or Independent Contractor?

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

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

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

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

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

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

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

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

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

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

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

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

 

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The Rift Between Companies: Oculus v. Zenimax

ZeniMax Media and Oculus are embroiled in a dispute over the intellectual property rights incorporated in the Rift product.

ZeniMax Media and Oculus are embroiled in a dispute over the intellectual property rights incorporated in the Rift product.

Have you heard of the Oculus Rift (that loveable virtual reality company swept off its feet by Facebook)? How about legendary game designer John Carmack? If you haven’t by now, you absolutely should have! In any case, here’s your major takeaway: Beware the Employer! The situation playing out between Oculus and ZeniMax Media is an interesting one, and it is a useful lesson in what not to do. While we wait for this to unfold (either in the courtroom or behind closed doors), let’s see where things went wrong and learn from Oculus’s potential mistakes.

Our Legal Setup

On May 1, 2014, ZeniMax Media (the parent company of Carmack’s former employer, id Software), sent letters to Oculus and Facebook claiming rights in at least part of the IP in the headset. In other words, ZeniMax believes it owns rights in IP created by Carmack during the course of his prior work for ZeniMax’s subsidiary, and that some of that IP is embedded in the Oculus Rift headset.  On May 21, ZeniMax initiated a lawsuit against Oculus in the Northern District of Texas. The focal point of Oculus’s problems stems from two documents: John Carmack’s employment agreement (and other ZeniMax/id personnel as well) and a Nondisclosure agreement entered into between Oculus cofounder, Luckey, and Zenimax Media.

Employment Agreements: Be Cautious about who helps you

Entrepreneurs, if you seek someone’s help, be sure to have them take a look at their employment agreement! Almost always, an employment agreement will include provisions that immediately make the company the owner of rights in inventions created by the employee in the scope of his employment. Sometimes, there may be an out if the work is unrelated or outside the scope of the Employer’s work or agreement. However, that may be difficult to prove.

Prior to this whole mess, Luckey, a hardware developer had begun the development process on the “Rift” virtual reality (VR) headset. In 2012, John Carmack began corresponding with Luckey and asked for a prototype of the Rift headset to tinker with. This is where their trouble begins. In the complaint, ZeniMax constantly states that it was developing VR technology with Carmack heavily involved in that research. As a game company, ZeniMax researched VR technology specifically for game development. There exists some question as to whether or not they sought to bring a viable consumer hardware project to market.

Carmack’s specific employment agreement reads:

Employee agrees that all Inventions that (i) are developed using equipment supplies, facilities or trade secrets of id Software or the Company… or (iii) relate to the Company’s business or current or anticipated research and development will be the sole and exclusive property of the Company (ZeniMax) or its designee from the moment of their creation and fixation in tangible media…

In other words, even if Carmack did not use his employer’s resources in working on the Rift, his employment contract would still purport to transfer rights to the employer if the Rift relates to the employers “current or anticipated research and development.”  Additionally, Carmack and other ZeniMax employees are said to have used company resources and research to make both hardware and software (including the software development kit or SDK) improvements to the device.

According to ZeniMax, “Carmack made breakthrough modifications to the Rift prototype based upon years of prior research at ZeniMax.” When Carmack and his crew made improvements, the resulting intellectual property had been assigned to ZeniMax via the employment agreements. The complaint constantly tees up that ZeniMax (Carmack with id Software in particular) had been working on VR hardware and software research. However, record exists where Carmack states that this was his pet project.  [Is there something missing in the prior sentence?]

In any case, if the court sides with ZeniMax, these improvements become their property, including the SDK. Carmack had quickly taken to Twitter to protest saying that nothing he has ever worked on was patented. But that might not be the only issue. The code he wrote, which is automatically protected by copyright, became property of ZeniMax (under ZeniMax’s interpretation of the law and facts). Accordingly, it might be the case that ZeniMax owns certain parts of the code used in the Rift.  If ZeniMax was the owner of Carmack’s rights in code he developed, then Occulus would have had to reverse engineer its code, without incorporating any of the copyrighted content from the ZeniMax-owned code.  It might also be the case that Luckey and ZeniMax became co-owners in the software.

Nondisclosure Agreement: Now that it’s not yours, it’s not yours.

Under ZeniMax’s argument, the technology became confidential information and trade secrets of ZeniMax. This is what gives ZeniMax some ammunition (or rather a actionable claim). Their research and proprietary information that was confidential and not readily attainable had been used in the Oculus Rift. Oculus was using it to profit to the tune of a cool $2 billion from Facebook. This could constitute misappropriation, meaning ZeniMax’s proprietary information was stolen. Helping to solidify their claim, ZeniMax points to the NDA entered into between the Company and Luckey.

It was under this agreement that Carmack showed Luckey the improvements made to the Rift. This contract is what governed the relationship between Carmack’s team, ZeniMax, and Luckey. The definition of confidential information includes the work done by the employees of ZeniMax. If these facts are correct, Luckey would likely not be able to use the information without the permission of ZeniMax (for purposes other than those outlined in the NDA). If ZeniMax’s secrets are disclosed, they potentially lose any trade secret protection. Multiple times in ZeniMax’s complaint, the Oculus team is painted as having no software background and no particular VR experience. If these facts are true, this would help ZeniMax demonstrate that they did not reverse engineer the tech (an acceptable method of discovering trade secrets). Multiple email chains affirmed the notion that they needed Carmack. Only days after demonstrating the Rift improvements, Oculus LLC was formed in the state of California.

Negotiations

ZeniMax’s complaint does not paint a favorable picture of how Oculus handled its negotiations with ZeniMax. The only facts are those from the complaint, and we’ll have to wait for more to come to light to know the truth. It is understandable that an entrepreneur will desire to protect and profit from an idea they believe to be there own. But even if there is not a clear owner of intellectual property rights in an idea, an entrepreneur maybe able to secure clear title to important intellectual property by negotiating a business arrangement with others involved.  ZeniMax’s allegations outline what not to do in negotiating over intellectual property rights.  ZeniMax alleges the negotiations broke down in large part due to the Oculus team. According to the complaint, originally, Oculus was to grant ZeniMax some share of equity in the LLC. According to the complaint, Oculus demanded a worldwide exclusive license over the IP disclosed by ZeniMax pursuant to the NDA. Furthermore Oculus demanded marketing support from ZeniMax and 10,000 free copies of Doom 3 BFG edition (a game capable of showing off the Rift) for the Kickstarter campaign. In return, ZeniMax would receive 2% equity interest subject to a 3 year vesting schedule. Vesting would be dependent on Carmack’s ongoing involvement in the project. Oculus also proposed tht ZeniMax could pay an additional 1.2 million for another 3%. However, that term was eventually dropped.

In 2013, negotiations in total broke down. ZeniMax would eventually prohibit Carmack from working with Oculus. As a result, Carmack left the company to become the Oculus CTO. They then began poaching former members of Carmack’s team despite noncompetition provisions in his employment agreement specifically prohibiting this.  Again, this is all based on ZeniMax’s unproven allegations.  However, this provides an example of how aggressive negotiating posture and subsequent aggressive hiring decisions can inflame a situation and lead to litigation.

Conclusion

Clear title to fundamental intellectual property is typically critical to a startup’s success.  While Oculus was able to achieve a favorable exit, their outcome is likely the exception to the rule.  ZeniMax’s complaint in its recently filed litigation provides numerous examples of mistakes startups can avoid making in working with individuals employed by others or subject to NDAs.

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The Perils of Contracting Through Third Party Websites

MichelleSargentBlogPicThe internet has a wealth of resources for start-ups, from legal and venture financing blogs to form documents and state entity-formation pages. There are also many pitfalls to leveraging the internet that unknowing and uncounseled start-ups may not identify. One of these is the use of third-party websites to enter agreements.

For example, a start-up wants to use a contractor to develop some code for their mobile application. The start-up finds a website that allows parties to post a project that needs completing and has users make bids to win the project. (There are many such, or similar, websites, such as Freelancer.com, Elance.com, and Guru.com.) The start-up posts its project, and an unknown individual somewhere in the internet world is contracted to complete it.

On its face, this is an easy and low-cost way of finding work for hire. But what may the start-up not consider: Is its intellectual property protected? Is any intellectual property created by the worker assigned to the start-up? What happens if there is a dispute about the completion or quality of the work? What is the worker’s classification for employment and tax purposes?

1.  Worker Classification

Any time a company wants to bring in somebody to do some kind of work for the company, the company must address how to properly categorize the worker for employment and tax purposes. As this blog has previously discussed, in a January 31, 2013 posting by Tasha Francis on Hiring Tips for First Time Entrepreneurs, there are important ramifications to getting the classification correct. And the correct classification may not be the one that matches the start-up’s financial capabilities or expectations. In using third-party websites to locate workers, the classification problem is magnified because (1) there may be no explicit agreement or provision stating how the worker is classified, and (2) it is possible the website loosely uses terms such as “employer” and “employee”—even when categorizing independent contractor relationships.

The purpose of these websites is to allow companies to hire remote, unknown individuals who specifically market and offer their services through the website to perform a specific project, on a specific time schedule, for a specific fee. This seems to create a quintessential independent contractor relationship. Many of these websites’ terms of service, however, explicitly refer to the company seeking services as the “Employer.” And the generic terms of service may not describe the nature of the relationship between the two parties contracting for work—unless the parties independently choose to enter into a separate independent contractor services agreement (the terms of which may not conflict with any terms in the terms of service). Although a start-up may ultimately be protected by the actual nature of its relationship with these electronically engaged workers, the terminology and lack of a defined relationship is just one of many ways relying on a third party may undermine the company’s legal rights and relationships.

2.      Intellectual Property

For many emerging companies, their intellectual property is the company’s main—and potentially only—valuable asset. And seeking to protect this IP is often one of the first steps taken by lawyers representing start-ups. Yet, when an uncounseled start-up engages through a third-party website, it is highly unlikely any of the typical IP assignment or proprietary information protections are contained in the default terms of the relationship.

Now we will return to the company that retains a contractor to develop a mobile application. On the one hand, the company must send proprietary information to the contractor describing its business, what its vision is for the mobile application, specifics for its user interface, the types of users it envisages, etc. Without any nondisclosure agreement, this proprietary information will not be protected from the contractor disclosing it to other parties, or developing the information in third-party products. On the other hand, the contractor will be writing code and developing an interface that will be an integral part of the company’s platform and business plan. But without any intellectual property assignment provision, any copyright and other intellectual property in the work performed by the contractor will not belong to the company. Although it may seem distant to the start-up now, any outstanding, unassigned intellectual property gives individuals a future opportunity to come back and seek something from the company.

It is highly unlikely that a third-party website will contain default provisions sufficient to protect existing company IP or to assign any contractor-created IP. On the contrary, many of these websites include express disclaimers that they are merely acting as a portal and are not subject to liability for any claims under any IP laws. It does not, however, include any IP assignment language from contractors to users, or any default nondisclosure provisions. Therefore, unless a start-up independently identifies the need to draft a separate and independent agreement assigning any IP and protecting the confidentiality of any of its proprietary information, it leaves potential holes in its IP protections.

3.      Dispute Resolution

So what if the relationship created on this third-party website goes wrong, what can a start-up do? Here, there are two main considerations: Does the third-party website impose any dispute resolution conditions on users? And should litigation arise, where would it take place?

A brief survey of the terms of service of several of these third-party websites reveals the existence of mandatory dispute resolution or arbitration provisions. What do these mean? Say the start-up is unsatisfied with the quality of the work performed by a contractor and wants to renegotiate the rate it has agreed to pay for the services based on the poor quality: First, the parties may be required to attempt to independently negotiate and resolve any disputes. They may also, however, be prevented from renegotiating the fee for a project after it has begun. Therefore, the parties would be required to submit the dispute to the third-party website, which may grant itself the full power to resolve the dispute, including the determination of the documents that can be submitted in support of the dispute. Alternatively, the parties may be required to submit to arbitration in which the third-party website selects an arbitration team that makes a binding, irreversible decision on the dispute. In many of the terms of service for these websites, there are no express provisions providing for litigation between users. And insofar as the purpose of the website is to bring together individuals globally to provide services, there is the distinct potential that contractors may be judgment-proof—either geographically isolated or financially unable to be hailed to court in a foreign country to face charges for breach of contract or copyright infringement.

And what if the start-up wants to raise a dispute with the third-party website? There are the obvious broad disclaimers of all kinds of warranties, limitations of liability, and indemnification requirements. But the terms and conditions can also establish that the agreement is subject to foreign law with irrevocable and exclusive jurisdiction in foreign courts. For uncounseled start-ups, the potential pitfalls of being unable to dispute a contract—because litigating abroad is unfeasible—were probably never considered.

These provisions and examples reveal the unforeseen liabilities of entering into agreements through third-party websites. Even for start-ups that may benefit from legal advice in order to draft separate agreements dealing with IP and worker-classification issues, it is likely that the third-party website’s terms and conditions will seek to limit the effect of these agreements to the extent they may be inconsistent with the website’s terms and conditions. And so even extra-website attempts to contractually change dispute resolution procedures may be ineffective. Nonetheless, there are differences in the terms of service across these websites, with some providing for more default, start-up friendly provisions or options to protect IP, classify workers, or dispute services, and at the very least, start-ups may want to consider digging deeper before selecting a third-party service.

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Books for Entrepreneurs and Their Attorneys

We are often asked at the Entrepreneurship Clinic about good books for those starting their own companies and for attorneys aspiring to be better-versed on startup issues.  The following are resources we often recommend.

Finding a Repeatable and Scalable Business Model:  One of the most important things for entrepreneurs to understand is the importance of identifying their potential customers and understanding what those customers want.  The following books are essential texts for understanding the importance of customer discovery and development and validating one’s value proposition hypothesis before wasting resources building something that customer’s won’t buy.

Startup guru Steve Blank's best selling work on customer development.

Startup guru Steve Blank’s best selling work on customer development.

 

Business Model Generation by Alexander Osterwalder and Yves Pgneur walks you through the process of building your business model (note: different than a business plan).

Business Model Generation by Alexander Osterwalder and Yves Pgneur walks you through the process of building your business model (note: different than a business plan).

 

The Lean Startup by Eric Ries stresses learning what your customer wants before investing time and other resources in product development.

The Lean Startup by Eric Ries stresses learning what your customer wants before investing time and other resources in product development.

 

Steve Blank and Bob Dorf's step by step guide to developing customers and validating a business model.

Steve Blank and Bob Dorf’s step by step guide to developing customers and validating a business model.

Legal Basics for Entrepreneurs:  Entrepreneurs face numerous legal issues in the early stages and it is important for entrepreneurs to have a basic understanding of common startup legal questions (such as incorporation, IP, employment law, early stage financing, contracts) so they can be a smart consumer of legal services.  The following books are essential guides for entrepreneurs or attorneys seeking to become more familiar with startup legal issues.

 

The Entrepreneur's Guide to Business Law by Bagley and Dauchy has been required reading in our Entrepreneurship Clinic since day 1.

The Entrepreneur’s Guide to Business Law by Bagley and Dauchy has been required reading in our Entrepreneurship Clinic since day 1.

Not So Obvious by patent attorney Jeffrey Schox explains patent law for non-lawyers in plain language.

Not So Obvious by patent attorney Jeffrey Schox explains patent law for non-lawyers in plain language.

Equity Compensation:  Almost all startups rely on equity (such as restricted stock or options) to incentivize employees.  The following book provides a comprehensive, and plan language, explanation of the business, tax, and legal issues related to equity.

 

Consider Your Options by Kaye Thomas walks through equity compensation for startups, including restricted stock, options, tax issues, etc.

Consider Your Options by Kaye Thomas walks through equity compensation for startups, including restricted stock, options, tax issues, etc.

 

Venture Financing:  The goal of most startups is to attract outside capital in order to rapidly scale their business.  The following text by venture capitalists Brad Feld and Jason Mendelson explains the mechanics and substance of venture capital deals in an easy to understand way.  They also include insights from entrepreneurs and focus on which terms matter, and which terms don’t.

Venture Deals by Brad Feld and Jason Mendelson explains venture financing concepts in plain language.

Venture Deals by Brad Feld and Jason Mendelson explains venture financing concepts in plain language.

The Entrepreneurial Mindset:  The following book provides a great insight into the “entrepreneurial mindset” and can help entrepreneurs better understand themselves and those around them.  It also can help those who work with entrepreneurs to better understand their colleagues or clients.

John Gartner's profiles on success stories like Christopher Columbus, Alexander Hamilton, Andrew Carnegie, and Craig Venter depict "the Link Between (a Little) Craziness and (a Lot of) Success."

John Gartner’s profiles on success stories like Christopher Columbus, Alexander Hamilton, Andrew Carnegie, and Craig Venter depict “the Link Between (a Little) Craziness and (a Lot of) Success.”

Enjoy your reading!

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How to Find Software Development for a Minimally Viable Product

 

Startups often find themselves in search of developers for their minimally viable prototype.

Startups often find themselves in search of developers for their minimally viable product.

A common issue for startups is where to find software development services to create a minimally viable product.  In lean startup methodology, a minimally viable product is a product with the minimal feature set needed to gauge customer needs.  Generally speaking, startups have three options if they do not already have a software developer on their team:

1.  Find a Technical Co-Founder – A startup may consider finding a software developer that would be a good fit to take the role of a technical co-founder.  This would typically require finding a software developer willing to make a full-time commitment to your startup.  Startups should also look for a good alignment of values, personality, and interests with a potential founder.  The trouble with this strategy is that it might take time to find, and become comfortable with, a suitable co-founder.  The diligence needed to find a co-founder may be inconsistent with a startup’s timing for developing a minimally viable product. The main benefit of having a co-founder capable of leading the development of a minimally viable product is that it is easy to make the necessary iterations to the product based on what a startup learns from its customers.  A technical co-founder is typically initially incentivized with founder’s equity, subject to a standard vesting arrangement.

2.  Use Independent Contractor Developers – If a startup does not have a technical co-founder, or if that co-founder needs additional assistance in creating a minimally viable product, a startup can often engage individual software developers through an independent contractor relationship.  These programmers should sign an independent contractor agreement or software development agreement with terms covering IP assignment, deliverables, and payment.  This relationship benefits the startup because it provides quick software development services for a minimally viable product, yet doesn’t commit the startup to a long-term relationship.  Also, because these independent contractors will be familiar with the startup’s technology, they may be available to tweak and improve the code based on customer feedback.  Independent contractors can be compensated with pay or with relatively small chunks of equity.  An additional benefit of this arrangement is that it could serve as a trial run for a potential technical co-founder.

3.  Use of Professional Software Development Providers – There are also companies that specialize in software development.  These companies range from high-end providers with extensive software development bandwidth and expertise.  These providers may take equity compensation from certain clients but will typically require monetary compensation in the ten’s of thousands of dollars. Smaller development firms may be less expensive or more willing to accept equity a full or partial compensation.  The drawback of using a development firm is it might be harder and more expensive to use that firm for the necessary iterations required after customer feedback.  Most firms will use their own developer-favorable agreement to cover the services they will provide, IP ownership, and payment terms.