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Dividends — Who Cares?

When a startup seeks financing, at some point the topic of dividends may come up. It seems everyone has heard of dividends, but who really cares about them? Generally, dividends are not as important as many of the other term sheet provisions, but you may encounter an investor who gets hung up on them (private equity types love dividends, while venture capitalists typically couldn’t care less). Why?

First, what is a dividend? A dividend is a distribution of the company’s cash or stock to its shareholders. Seems simple. But, naturally, lawyers have made it more complicated than that. For example, there are cumulative and non-cumulative dividends. With a non-cumulative dividend, if the company does not declare a dividend during the fiscal year, then the right to the current dividend is relinquished. On the other hand, with a cumulative dividend, the right to receive the dividend is accumulated until it is paid or terminated. This all sounds important, but in reality, early-stage startups rarely have any cash to distribute, and stock dividends lead to dilutive problems.

Dividend language may look something like this:

Series A Preferred Stock will carry an annual [insert dividend percentage, typically in the range of 8%]% cumulative dividend [compounded annually] of the Original Purchase Price in preference to any dividend on the Common Stock payable upon a liquidation or redemption. For any other dividends or distributions, the Series A Preferred Stock will participate with Common Stock on an as-converted basis.

So why am I questioning the importance of dividends? Because dividends cannot provide the type of return that venture capitalists are looking for. This can be shown by doing some easy math. Assume a dividend of 10% (dividends typically range from 2.5% to 15%, depending on the investor – using 10% keeps the math easy). Venture capitalists are typically swinging for the fences, not trying to generate returns for their investors from their companies cashflow. A successful return in a VC’s mind is likely closer to 10x her investment, not 10% per annum.

Assuming your VC receives a favorable 10% automatic annual cumulative dividend (without the compounding aspect to keep the math simple), it would take the VC 100 years to get her 10x return through the dividend. With a 10% dividend, a VC will only get 1x her investment if she holds the investment for 10 years. In general, a venture deal has a 5 to 7-year lifespan; with a 10% automatic annual cumulative dividend, the VC will never reach the 10x return from the dividend alone.

When can a dividend matter? Dividends can create and build an internal rate of return on an investment that will be realized upon redemption or exit through sale or an IPO. In other words, a dividend can provide downside protection to the investor. Let’s consider a $50M investment with a 15% cumulative dividend that is acquired after three years for $100M. If we assume a straight (or non-participating) liquidation preference and that the investor received 33.3% of the company for her investment (a $150M post-money valuation). Because the $100M sale price is less than the $150M post-money valuation at the time of the investment, the investor will use her liquidation preference to receive her original $50M plus any accrued dividends. In this case, the accrued dividends, assuming they were accumulating and not being paid, would be $22.5M ($7.5M per year for 3 years). Here, if the VC did not have a dividend, the VC would have foregone an additional $22.5M to protect this (losing) investment.

Well if a dividend provides downside protection, then why wouldn’t it be an important provision? Because we are assuming the company can or should actually pay out a dividend. As mentioned above, dividends can be paid out in cash or stock, usually determined by the company. If the dividend is paid out in stock, it leads to additional dilution of ownership. If the dividend is paid out in cash, it might be depleting the company of necessary resources.

An automatic dividend can also cause significant trouble for the company. It’s important to include any automatic dividends in a solvency analysis, as an automatic cumulative dividend could unknowingly thrust you into insolvency.

Many VC’s recognize that by insisting on receiving a dividend, they may actually lower their return on investment by sucking the company dry. Dividends are more common in private equity investments because the investment amounts are typically larger (typically greater than $50M) and less risky. The larger the investment and the lower the expected exit multiple, the more a dividend comes into play.

If an investor insists on receiving a cumulative dividend from your early-stage startup, know that the investor might not have your growth as a high priority. Make sure you do the math and understand how the dividend may impact your piece of the pie upon an exit. And just because everyone has heard of a dividend, doesn’t mean every company should be offering one.

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The Basics of Patent Licensing

Part I: Is there an IP licensing opportunity?

Are you an inventor or an entrepreneur?

From KickStarter and Shark Tank to Tesla and Facebook, people are excited about innovation. Sure, Elon Musk and Mark Zuckerberg achieved incredible success, but their stories are one in a million. The truth is almost all startups fail. This article presents intellectual property licensing as an alternative to the startup route.

If you enjoy discovering customers, creating markets, and developing teams, then you may be an entrepreneur. A successful path may be to create a company and work on an exit strategy. On the other hand, if you enjoy discovering problems, creating inventions, and developing products then you may be an inventor. A successful path may be to create an intellectual property portfolio and work on a licensing strategy.

 

What can you do with intellectual property?

Intellectual property (IP) generally refers to creations of human intellect and creativity that governments reward by granting property-like rights to their creators. The basic types of IP are patents, copyrights, trademarks, and trade secrets. Patents protect new and useful inventions; copyrights protect original works of authorship; trademarks protect the goodwill of a business or brand; and trade secrets protect confidential valuable business information. For simplicity, this article focuses on licensing of product patents.

Assign a patent

An assignment is the transfer of IP rights from one owner to another, for example from an inventor to a company. This must be done in writing, and is often accomplished by language like “For good and valuable consideration I hereby assign all right, title, and interest in my Invention X to Company Y.” Assignments commonly occur when the assignor (e.g., inventor) prefers an immediate payment over a potentially larger but less certain payment in the future. Assignments are also common when the assignee (e.g., company) prefers to have control or ownership of the IP for strategic, accounting, finance, or tax purposes.

License a patent

Instead of “outright selling” IP rights as an assignment, an inventor may “lease” them as a license. IP Licenses are usually in writing due to their complexity, but they can be oral. The prototypical license establishes a running royalty to be paid by the licensor (e.g., company) to the licensee (e.g., inventor). Both parties may benefit from a license: the licensor can expect robust royalties if the invention achieves market success, and the licensee can expect not to pay royalties if the invention fails in the market.

Dedicate a patent to the public

An inventor can simply give away his IP or abandon it altogether. This is not generally a viable monetization strategy, but it may be a way to earn credibility as a prolific inventor or to absorb goodwill of a company who will put an invention on store shelves.

 

How are the relevant industries and markets configured?

Some inventions have a very specific market and an obvious distribution channel, for a non-stick frying pan. But some inventions span multiple markets, for example a low-friction coating. Understanding the markets are how they are configured can be a good starting point for licensing.

Non-exclusive license

A non-exclusive license gives a licensee the right to exploit the IP, but the licensor may grant additional licenses to others concurrently. This can be advantageous for a licensor when his IP improves a product made by several companies having roughly equal market share, for example computers or shoes. Several lower royalty-rate licenses to several companies can earn substantially more total royalty revenue than a single higher royalty-rate license to just one company.

Exclusive license

An exclusive license gives the licensee the right to exploit the IP, and the licensor may not grant additional licenses to any other party, nor may the licensor exploit the IP himself. Consequently, the royalty rate is usually higher than for a non-exclusive license. The scope of exclusivity can be based many parameters, such as field of use, geographic territory, or market channel. Exclusive licenses can be advantageous for both parties when the licensee is a large company with national or international channels to market. But they can be disastrous for a licensor when the licensee has insufficient market power to create or satisfy market demand.

Sole license

A sole license gives the licensee the right to exploit the IP while permitting only the licensor to continue to exploit the IP. This is an uncommon arrangement that sometimes arises in cross-licensing agreements (where two parties each have intellectual property that the other wants to exploit).

 

Hedge your bets against an uncertain future.

An inventor may believe in the long-term market potential for his invention, but he may be uncomfortable relying solely on speculative future earnings from IP licensing. In this case the inventor may wish to trade-off some running royalties (future) for an up-front payment (present). 

Up-front payment (lump-sum royalty)

An up-front payment, also called a lump-sum royalty, is a dollar amount the licensee pays to the licensor usually at or near the start of the license term. If the licensor suspects the IP is so weak that it may be easily designed around or that the technology is changing so rapidly that what is valuable today may be obsolete tomorrow, he may wish to trade-off running royalties for an up-front payment. On the other hand, if the licensee believes the market is unstable or consolidating or that the market is so competitive that a design-around is inevitable, it may wish to omit an up-front payment altogether. However, maximizing an up-front payment can be detrimental to both parties. It can limit how much cash the licensee has available to commercialize the invention, resulting in either poor execution and a product failure or slow time-to-market and a missed market window.

Running royalties

Running royalties are amounts paid to the licensor over time based on the revenue earned by the licensee from sales of products that embody the licensed IP. A licensor may wish to forego an up-front payment for higher running royalties if he believes the IP is so strong that it may never be designed around or that the technology is either unchanging or so fundamental that its value will endure. Similarly, a licensee may wish to offer an up-front payment if it believes the market is stable or growing or that it has so much market power that design-arounds are not a concern. However, maximizing the running royalty can be problematic for both parties. If the licensee erroneously assumes a rapidly growing market and continued market power, it may fail to achieve the economies of scale necessary to support the high running royalty.

Combination of up-front payment and running royalties

Up-front payments and running royalties are not mutually exclusive. It can be beneficial for both parties to balance these appropriately.

 

Part II: How to optimize an IP license?

What types of products will embody your IP?

Running royalties, commonly just “royalties,” are generally proportional to how well the licensee exploits the IP. The two most common methods to compute royalties are based on sales revenues (dollars) and based on units sold.

Royalties as a percent of sales

Royalties as a percent of sales—typically net sales and rarely gross sales—can be beneficial for licensors whose IP is embodied by expensive and low-volume products, or for products whose price is expected to increase over time. The percentage is normally fixed but can vary proportionally with sales volume.

Royalties per unit sold

Royalties based on the number of units sold can be beneficial for licensors whose IP is embodied by inexpensive and high-volume products, or for products whose price is expected to decrease over time. Like percent-of-sales, the per-unit rate is normally fixed but can proportionally with sales volumes.

Royalties per use

Technology that tracks user’s usage has given rise to royalty rates based on the number of times a product is used. Example uses may be when a user opens a smartphone app or when he queries a cloud-based server. The former is similar to royalties per unit whereas the latter is similar to royalties as a percentage of revenue.

Royalties per unit time (lump sum)

Sometimes it can be easier to compute royalties based on time, for example how long a computer program is active. Time-based royalties can use computed per month, minute, or any duration make sense.

 

What should you base running royalties on?

Licensors often focus on the royalty rate—believing higher is always better. But this is only half the story:

Licensor: “I’m so happy. I negotiated a 10% royalty rate!”

Friend: “Great! But 10% of what? Gross sales? Net Sales? Profits?”

Royalties based on gross sales

In most cases gross sales is simply the total of all invoiced amounts, in other words what the licensee charged its customers. It is rare to base royalties on gross sales, especially in industries like retail where it is customary for vendors (licensees) to pay for shipping, markdowns, and volume discounts.

Royalties based on net sales

Net sales is gross sales minus expenses related to the sale of products, for example shipping, returns, and trade allowances. This is the most common basis for royalty rates; however, it can be easily overlooked or misunderstood. A seemingly high royalty rate can be eviscerated by excessive deductions.

In many industries it is common to deduct the following expenses:

  • Volume discounts. These usually increase total sales and therefore both parties benefit.
  • Product returns. It can be unfair to pay a royalty on such an unprofitable transaction.
  • Product freight and insurance. Customary.
  • Local taxes. Customary.

A licensor should generally resist permitting the licensee to deduct of the following expenses:

  • Sales commissions. This can encourage a licensee to pay excessive commissions.
  • Marketing and/or advertising. These are normally the licensee’s costs of doing business.
  • Unpaid debts. The licensor should not be accountable for the licensee’s customer management.
  • Vaguely specified fees. Such catch-all categories can become sources of contention.

It is beneficial for a licensor to cap the total amount of deductions to some percentage of gross sales.

Royalties based on profits

Because there is so much variability in companies’ financial management and accounting, it is best to simply avoid using profits as the basis for royalties.

 

When should running royalties accrue?

A licensee almost always computes royalties when it ships goods, invoices for those goods, or receives payment from its customers. 

Accrue royalties on shipment

Computing royalties when products ship can be an attractive option for licensors who rely on royalty payments for cash flow. However, if net revenue is the basis for royalties and there are extensive or delayed deductions, then accrual on shipment can complicate bookkeeping. For example, if the licensee pays the licensor quarterly royalties but it credits buyers for volume discounts annually, then the licensor may need to pay back the licensee for royalties paid in excess.

Accrue royalties on invoice

Computing royalties when products are invoiced is very common because it provides a clear basis for computation—the invoice quantity or amount. In practice, sellers often invoice buyers shortly after they ship products, so there may not be much practical difference in timing between accrual on shipment and accrual on invoice.

Accrue royalties on payment

Computing royalties on payment uncovers a subtle issue—not only does accrual determine when the royalty payments become payable, but it determines what the royalty payments are based on. Royalties that accrue on payment are based on products the licensee sold and received payment for. In other words, if the licensee never receives payment from a customer, then the licensee will pay no royalties on those products. A good way for licensors to negotiate against accrual on payment is to remind the licensee it is the licensee’s responsibility to choose its customer wisely.

 

How to ensure your IP is adequately commercialized?

An IP license can be worthless if the IP is never commercialized. Licensees sometimes exclusively license IP to prevent that IP from being commercialized (called shelving), usually if the licensee wants to protect its own competing product. A licensor should negotiate for some sort of assurance that the licensee will work diligently to adequately commercialize the IP.

Milestone payments

If the license agreement is for an invention that requires significant time to commercialize, then it is customary for the parties to determine a schedule of milestones for the licensee to achieve. The licensee almost always pays the licensor a lump-sum amount for each milestone it achieves. The license agreement should clearly express what happens when the schedule slips for various reasons. Example milestones are “building a functional prototype” or “starting clinical trials.”

Minimum royalties

A minimum royalty is a quarterly or annual amount that the licensee must pay the licensor whether or not the licensee sells enough products to generate adequate royalties. This may be the most important provision of an IP license because it provides the licensor with some certainty for future income.

Minimum royalties align the parties’ expectations of the commercial value of the licensed IP. For example, assume the parties want an exclusive license for a simple invention having a market size around $10 million and agree to a 5% royalty on gross revenue. This should generate expected annual royalties of roughly $500,000. So if the licensee refuses to agree to a minimum annual royalties above $100,000, then it means the licensee may expect to capture just 20% ($2 million) of this market ($2 million * 5% = $100,000). In this case the licensor may want to propose a non-exclusive license with this licensee or to explore exclusive licenses with other companies who are more confident that they will fully serve this market.

Importantly, minimum royalties provide a straightforward way for to modify or terminate an agreement with an underperforming licensee. For example, if the licensee falls short of one minimum royalty payment then the license could convert from exclusive to non-exclusive; if the licensee misses two payment then the license could terminate. Minimum royalties are no guarantee of commercialization, though, because the licensee can usually just pay these minimums out of pocket—as long as it can afford to do so.

 

Who should get rights to improvements to the IP?

It is important to consider whether the IP may be further developed and by whom. Which party will own and/or have rights to such improved IP depends on many factors, including: (1) the size, sophistication, and business models of the parties; (2) the strength and maturity of the IP; and (3) the amount of research and development required to commercialize the IP. A reasonable rule of thumb is that the party who creates some improved IP owns that improved IP.

Retain ownership to improvements

A licensor whose business is creating and licensing IP may want to negotiate to retain rights to all improved IP created by either party. This prevents the licensee from inventing around the licensed IP and thereby undercutting the licensor’s business. A licensor may retain ownership of improved IP but agree to license it to the licensee at some fair market value.

Grant ownership to improvements

Most licensees want to own improved IP that its employees create or which it paid to have created. This is a reasonable expectation, especially when the licensee is in a better position than the licensor to file, prosecute, and maintain the improved IP. Further, a licensee may ask for an automatic license to all improved IP created by the licensor. While seemingly unfair, the licensee is simply protecting its investment in the licensed IP. This prevents the licensor from creating improved IP and then demanding additional royalties and/or up-front payments while threatening to take the improved IP to a competitor.

Agree that each party owns improvements it develops

Licensors and licensees generally operate at arm’s length and may therefore further develop the IP without regard for the other party. In this common situation each party pays to develop and protect the improved IP it creates, and consequently owns such improved IP. Whether the other party gets rights to the IP up for negotiation.

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“We Don’t Have Any Intellectual Property”: Responding to a Common Startup Misconception

Whenever we meet with a new or potential startup client, one of the questions we always ask is what intellectual property the company has that it might want to protect. Frequently, entrepreneurs will respond with “we don’t have any intellectual property.” However, more often than not, this is not the case. This post aims to help an entrepreneur to begin thinking about the valuable intellectual property that her company may possess. It serves as an overview of all of your company’s assets that may fall under the “intellectual property” umbrella, and which you might be able to protect.

 

Patent

The first type of intellectual property that comes to mind for most entrepreneurs is the patent. Patents generally protect the following types of inventions:

  • Processes
  • Machines
  • Improvements
  • Composition of matter
  • Plants (asexually reproducing)
  • Designs (ornamental designs, separate from functional elements)

Patentable inventions must be useful, novel, and nonobvious. There is no patent protection for laws of nature, natural phenomena, or abstract ideas. This means that algorithms, especially purely mathematical ones, may not be patentable.

 

Copyright

Copyright protects literary and artistic expression that exhibit a modicum of originality and that are fixed in a tangible medium of expression. These literary and artistic expressions that may be eligible for copyright include:

  • Books, poetry, dramatic works
  • Music
  • Dance
  • Computer programs — both the underlying code and the interface
  • Movies
  • Sculptures
  • Images, paintings, drawings, photographs
  • Designs
  • Architectural works

Note that ideas that underlie a work are not copyrightable. Instead, they may fall under the umbrella of patent. Additionally, functional elements of anything are not copyrightable.

 

Trademarks

Trademark is another aspect of intellectual property law that you have likely heard a lot about. What you may not know is what exactly trademark law can protect. Under the federal trademark statute – the Lanham Act – words, symbols, and other attributes that serve to identify the nature and source of goods or services can be protected by trademark. The following marks may be protectable under trademark law:

  • Company names
  • Product names
  • Symbols
  • Logos
  • Slogans
  • Pictures or designs
  • Product configurations
  • Product design or trade dress
  • Colors
  • Smells

The limit here is that, to receive trademark protection, the mark needs to identify to consumers the source of the good or service it identifies. In other words, it must call your company or its goods or services to mind. Additional limits include that the mark must not be a generic description of the good or service or the class of goods or services, and that the mark cannot be a functional element of the product.

 

Trade Secrets

Trade secrets are information that adhere to the following three rules: the information (1) is not generally known to or reasonably ascertainable by the public, (2) confers to your company an economic advantage (meaning the secrecy confers the value, not just the information itself), and (3) is subjected to reasonable efforts by your company to maintain its secrecy. Trade secrets can include business or technical information of any sort. This means that things eligible for trade secret protection may include:

  • Formulas (chemical)
  • Recipes
  • Data
  • Methods or techniques
  • Processes
  • Business plans (e.g. product plans, sale and marketing plans, business strategies)
    Customer lists (current, past, and prospective)
  • Supplier lists
  • Pricing, price lists, pricing methodologies, profit margins
  • Market studies
  • Computer software and programs (including object code and source code)

Any information that meets the above three criteria can be protected under trade secret laws. The above list is not inclusive of all things that may qualify as trade secrets. Note that independent discovery or invention, as well as reverse engineering, of the information contained in your trade secrets is not prohibited under this regime.

 

Why Is This Important?

Intellectual property can be one of the most valuable assets to your company.

Disney’s stories and characters are protected by copyright. Nike’s famous swoosh logo and “just do it” slogan are protected by trademark. Trademark also protects the iconic red of the soles of Louboutin shoes. Coca Cola’s Coke formula is one of the most heavily guarded trade secrets. The curved designs of Apple’s Macbooks and iPhones casings are protected by design patents. Think of where all these companies would be without their intellectual property and the regimes that protect it.

Identifying your intellectual property is your first step to protecting and monetizing it. Whether this means filing a federal application, maintaining a trade secret, or simply asking founders and workers to assign to your company intellectual property they have created, this can be one of the most important parts of your business. So go ahead and start keeping track of assets that may qualify as intellectual property.

 

Conclusion

 For a lot of this, there is a much deeper analysis of whether your particular work, mark, or invention is actually protectable under one intellectual property regimes, to what extent, and how to go about acquiring and maintaining such protection. For more details about those analyses, consult with other posts on this blog, or an attorney.

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Protecting Corporate Intellectual Property

Intellectual property is a critical asset in many startups, especially technology startups, and often provides the foundations for the value proposition of the business. As a result, it’s very important to ensure that this intellectual property belongs to the company and not to various founders, employees, contractors, or any other contributors.

 

There are numerous potential negative consequences that can occur when intellectual property isn’t adequately protected. For example, situations can arise where an individual informally yet intimately involved in the company leaves without ever transferring the intellectual property he or she has contributed. Even where an individual’s relationship with the company was formal and agreed upon in written contracts, if intellectual property is not properly assigned, the company may not own it. Both situations, along with a myriad of other possible scenarios, can result in costly litigation. Long, expensive legal battles over intellectual property can easily destroy a young company that often can afford neither the actual cost nor the corresponding damage to the company’s reputation, especially because relationships are so often critical to a startup’s success. There is also always the possibility that the company will ultimately lose in litigation, and the loss of critical intellectual property components can seriously damage a company’s value.

 

While it’s important to engage legal counsel to aid in protecting your company’s intellectual property, it’s still valuable to understand the basics as an entrepreneur. This post will describe a few of the basic notions central to the protection of intellectual property protection:

  • Intellectual property assignment
  • Proprietary information and inventions agreement (“PIIA”)
  • Works made for hire
  • Shop rights
  • Licenses

 

Intellectual Property Assignment:

A first step is often ensuring that all intellectual property created prior to these measures is affirmatively assigned to the company. Here, it’s important to think critically about who may have contributed any type of intellectual property. Beyond standard technology, consider anyone who might have contributed to the development of trade secrets, a designer who helped with a logo, or even someone who came up with the company name or slogan. If all the people involved in creating any form of intellectual property do not sign an assignment, then there are already gaps in your company’s foundation.

Once you determine who needs to sign an assignment, it’s important to make sure that the scope of the assignment includes the specific variety of intellectual property that you want assigned and that the correct legal words are utilized to make the assignment valid. These are points you should always be sure to confirm with legal counsel.

PIIA:

It’s also important to ensure that any intellectual property developed forward is retained within the company, and PIIAs can often help meet this goal. PIIAs include language constituting a nondisclosure agreement and provisions assigning intellectual property created during a specified term (commonly the term of employment) to the company. The breadth of the intellectual property that a PIIA covers is typically up to the drafter, and it will be important to discuss with counsel what you intend to accomplish with any PIIAs that you request. Some PIIAs can even assign ideas conceived by individuals during the term of their employment.

Works Made for Hire:

Some specific types of intellectual property are protected by the works made for hire doctrine under copyright law. This is a complicated doctrine, and is often less useful than anticipated by entrepreneurs. It only protects works that are created in a “fixed form,” and only applies to specific items. Moreover, it only applies to works created by employees or works specially commissioned and only in very specific circumstances. Because intellectual property protection under this doctrine is so scant, it’s best not to rely on it and to have other protection mechanisms in place.

Shop Rights:

Shop rights occur when intellectual property is created by an employee and applies to inventions or patents. This right is not codified in law, but is an equitable judge-made solution for instances where an employee utilized an employer’s resources in creating an invention but never assigned ownership to the employer. This right is similar to a non-exclusive, no-cost license; the company can use the invention without paying any fee to the former employee, but has no ownership rights and cannot prevent anyone else from using the invention. While shop rights can somewhat protect your business model because you are not at risk of losing a critical invention, they cannot protect you from competitors.

Licenses:

Licenses can also be a useful tool to gain access to more intellectual property that was not created within the company. There is often open source code available for use in software, and using these usually entails some type of license agreement. Licenses are also useful in obtaining freedom to operate if your company’s invention is not useful without utilizing the invention of another entity.

 

In general, it’s important to establish measures to protect your intellectual property early. Many founders don’t like to spend time on this because it doesn’t typically have an effect in early day-to-day operations of the company, but it can make an enormous difference down the line if this framework is or isn’t in place in the event of a dispute. More importantly, it is very difficult if not impossible to remedy weak intellectual property protection once a dispute has already arisen.

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Should Start-ups Utilize the Blockchain Over Deal Lawyers?

In the current model of American commerce, business attorneys are uniquely situated between firms and opposing parties. A great deal of an attorney’s utility comes from her experience with deals and position as a utility player. But have we considered how recent innovations potentially threaten this traditional model?

Blockchain is the generic name for the technology underpinning Bitcoin, the world’s most notorious cryptocurrency. It is a distributed public ledger system. Transactions are recorded on a comprehensive and always up-to-date public register that every bitcoin enthusiast can download and verify. Those familiar with cryptocurrency know that not even a single tangible bitcoin exists. Rather, “possession” of bitcoin is determined by a continuous barrage of 1s and 0s revolving around a common ledger. That’s about all one needs to know about bitcoin to understand how the blockchain could be applied to transactions generally.

Smart Contracts are another potential implementation of blockchain technology in addition to cryptocurrency. Blockchain software code can represents an arrangement or contract. The computer can make and execute automatically under conditions set in advance. It doesn’t end there — the system could execute bundles of agreements, all linked to each other, operating autonomously and automatically. The vanilla version requires that all the links in a contractual chain need to execute. For simplicity, I’ll focus on a simple one step transaction between a buyer and seller.

A case study for how this could work in practice is to look at Amazon smart lockers. When a consumer on Amazon’s retail store purchase an item and elects to utilize a smart locker, the item is shipped to a predetermined location — the locker — and the customer arrives, verifies his identity and takes possession of the good. The consumer experience could be identical with the blockchain. Rather than rows of computer hardware running Amazon’s web services, the decentralized ledger system could run a near constant accounting of who has paid for certain goods and services. For example, consider if the local ice cream maker needs to make monthly purchases of dairy from the dairy farmer several counties away. The ice cream maker can avoid the time spent physically contacted the farmer or an agent of the farmer every month to verify the deal is still on. Also, the ice cream maker could avoid any risk that the farmer could not deliver.

An example of how this could play out is like the Amazon smart locker solution. Consider the farmer usually delivers dairy to a group of merchants in Washtenaw County. Rather than verify every transaction, the farmer could arrange for a neutral site to store the commercial dairy. That site could be outfitted with locks connected to their own private blockchain. Once the farmer’s bank receives payment for the dairy it could send a digital receipt back to the merchant; this key would then unlock the merchant’s unique locker when she presented identification at the locker.

This is a simplified example and the point of service could look a lot different whether the solution is taken up by private companies like Amazon or municipalities consider operating their own blockchain infrastructure. The point is to consider where do lawyers fit into all of this? According to Jeff Garzik, co-Founder at Bloq, a blockchain services startue: none at all. “Smart contracts … guarantee a very, very specific set of outcomes,” he observed. “There’s never any confusion and there’s never any need for litigation. It’s simply a very limited, computer-guaranteed set of outcomes.” Mr. Garzik is undoubtedly discounting the propensity for things to go wrong in a deal, but there may be some potential for this to be the reality. It merits attention from the legal profession and law schools.

For low level, standardized agreements (like purchasing from a dairy farmer) the lawyer’s role would likely be one of overseeing the system and arbitrating any disagreements that may arise. This may require a baseline understanding of the technology in addition to solid understanding of commercial law.

The upshot: the end may not come swiftly. While this may eventually lead to a long run decrease in the demand for legal services for some types of transactions, it’s important to note that this is part of a longer trend of technology reducing transaction costs. Qualified lawyers will always be able to provide intangible services like effective counseling and guidance to small businesses. That will remain indispensable despite any foreseeable technologic advances. Corporate attorneys command high fees for the work they do with very sophisticated parties crafting bespoke agreements. At the low end, some contracts have been becoming more standardized, a la Legal Zoom. But nothing about smart contracts in its current form presents an issue for transactions driven by complexity.

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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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How to Avoid the Deal-Killer Attorney

I can only imagine the nightmares keeping entrepreneurs up at night…Cap tables, pitchdecks, and software, oh my! Not least among a founder’s fears is often the deal-killer attorney—the inflexible attorney who overlawyers, sweats the small stuff, and seems not to give a care about a startup’s wellbeing.

Some attorneys may deserve this “deal-killer” moniker due to their veritable rigidity, boneheadedness, or ungenerosity. But not all lawyers who are perceived as deal-killers are such inconsiderate dunces.

Unfortunately, there really are many pitfalls for startups to fall prey to, creating insurmountable legal barriers. Although the attorney of course does not wish for a venture to fail, they must make a comprehensive analysis of several important factors. This post aims to explain how to avoid getting your “deal killed” by a lawyer.

 

Finding an Attorney

First and foremost, you must find yourself an attorney with whom you get along and feel you can trust. Not all legal tasks are so specialized, but with regards to startup law, it is critical to find an attorney who is experienced in this realm. If you don’t know where to start, try calling or emailing a nearby law school for recommendations or another disinterested source for reliable options.

 

Being an Attractive Client

Succeeding in finding this match is only half the battle; the lawyer must also see merit in you and your business. For some law firms (including legal clinics), acceptance can be quite competitive.

There are several strictly legal characteristics that a screening interviewer might require of your business.

  • Don’t infringe on someone else’s copyright or ideas, and use original material as often as possible. This not only applies to copying a business’s name or coding, but also smaller things like borrowing images. Even if someone gives you a photo to use, don’t assume they had the rights to give it to you.
  • Don’t have thirty founders. A company must be able to make decisions, and this is hard to do when it is impossible to get everyone in the room or on the phone at the same time. A tighter group of founders where each
  • Don’t do anything illegal. This one may seem obvious, but consider that it also applies to regulatory violations you may not know exist, and lawyers have an ethical obligation not to represent clients knowingly taking part in illegal behavior. Try to read up broadly on the regulatory issues of your industry to know what might apply to you.

There are several characteristics your screening interviewer might be taking special note of. Here are a few tips and tricks to understand before seeking counsel.

  • Be ready to tell your story. Know why you’re taking on a certain venture and be able to confidently and convincingly articulate this.
  • Have an idea of what you aim to achieve next, and express dedication to achieving that goal.
  • Although you don’t need to display impeccable business sophistication, a general understanding and concern for keeping the business end tidy can only work in your favor.
  • Do your research. Know what businesses exist with similar product ideas or names, and be ready to differentiate yourself.
  • Have more than simply an idea for a product or service; be able to demonstrate or discuss value the business has already created.

 

I’ve Got a Lawyer, Now How Do I Prevent Them from Killing My Deals/Ideas?

Finally, you need to have a sense of what your lawyer needs from you. If they have not communicated this, for goodness sake, ask them! Lawyers inevitably focus on different facts and circumstances than founders do, but there’s usually a reason for it. If it isn’t clear to you what issues your lawyer is prioritizing and why, it will be difficult to understand where the business is heading. Additionally, if you make your lawyer very aware your priorities and your level of risk tolerance, this open line of communication will promote an idea flow of flexible workarounds and creative solutions.

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Beware the Cap Table

So you founded your own company, congratulations! You came up with a great idea, built a team, and built a product. You are going to take over the world! But there is one thing standing in your way: money.

Startups can live and die by financing. The good news is that there are many different ways to raise money. One of the most popular/prestigious is to get an investment from an Angel or Venture Capital investor. Of course, whenever you raise money (even if it is convertible debt) you need to be aware that you are giving up a portion of your company. You may need the money, but equity is valuable, and you should protect it fiercely.

Equity is visualized/kept track of on something called a Capitalization Table (Cap Table for short). They are usually on an Excel spreadsheet, but more and more they are moving to online platforms like eShares.

Numbers and Excel spreadsheets can be super intimidating. But, founders, I encourage you to embrace the challenge and really understand your cap table. You should know it inside and out, and how different types and amounts of financing will change it. How well you understand your cap table will have far reaching consequences for the health of your company and your personal finances.

Unfortunately at the Clinic we see too many startups who take money from inexperienced investors and end up selling too much of their company too soon. While every company is different, here are some ballpark figures you should keep in mind:

  • Accelerators/incubators usually take somewhere between 5-10% of equity their portfolio companies for a combination of cash and services.
  • Angel/Series Seed investors should get somewhere between 15-33% of your company. The exact numbers depend on a number of factors, but if an investor is asking for more than 1/3 of your company at this early stage, that should raise red flags.

One of the best things you can do for your company and yourself is raise as little outside capital as possible. This means that you should bootstrap for as long as possible, and once you do raise money, be very diligent about how you use that cash so you can wait as long as possible before you raise more (if you raise more at all).

Companies that give up too much too early are in danger of scaring off future investors. When founders don’t own enough of their own company investors fear that founders, who are the heart and soul of the company, will no longer have incentives to work hard. We have seen this in several companies.

On the flip side, there are some recent success stories from the Ann Arbor ecosystem. While I won’t give away too many details for confidentiality reasons, there are some common threads. Each company raised a relatively small amount of capital (only a few million dollars, which I know sounds like a lot, but is tiny in this world). In every case the founders kept close track of their cap table and made sure they didn’t give up too much. When these companies sold, the majority of the purchase price went right to the founders, who still owned sizable (sometimes close to half) of the equity in their companies. When you are talking about acquisitions in the tens or hundreds of millions of dollars, every percentage point on the cap table is important. Many of those founders can now go on to be VCs, found another company, or never work again if they so choose.

So founders, don’t skimp on learning the ins and outs of your cap table, it will pay off in the long run!

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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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Losing Limited Liability: Blending Business and Personal Finances in a Corporation or LLC

 

In the early stages of starting a new business, it can be difficult to tell what belongs to the company and what belongs to the founders as individuals. Even after a business is formally incorporated as a corporation or limited liability company (LLC), the distinction between the person and the entity may not be clear, either from a practical perspective or an emotional one. With this in mind, it can be tempting for startup founders to blend their own finances with those of the business. After all, it often seems (perhaps even accurately) that the money is going to go to or come from the same place when all is said and done. Why not streamline things by cutting out some of the intermediate steps?

The reason why it is so important to keep personal finances and company finances separate is that failure to do so has a number of practical consequences. These range from tax implications—blending personal and corporate accounts can be a nightmare when it comes to filing taxes or preparing for an IRS audit—to the complete loss of some of the key advantages of incorporating in the first place. This blog addresses only one of these consequences: specifically, the risk that commingling corporate and personal finances can lead to the loss of owners’ limited liability for business debts or wrongdoing.

 

Loss of Limited Liability

One of the major reasons that founders choose to form a corporation or LLC for their own business is to limit their own liability in the event that the business is sued. Unlike a partnership or sole proprietorship, a corporation limits the degree to which the founders can be on the hook for any debts undertaken or legal wrongdoing engaged in by the company. Normally, corporate ownership will not be liable for more than the amount of capital they have already invested in the business. Their personal assets remain off-limits.

The limited liability aspects of a corporation are only fully effective, however, if the founders clearly differentiate between and separate their personal finances and the company’s finances. This is because, in some circumstances, courts may “pierce the corporate veil” and impose liability on officers, shareholders, directors, or members. A court may pierce the corporate veil if all the following requirements are met:

  1. There is no real separation between the company and its owners
  2. The company’s activities were wrongful or fraudulent
  3. The company’s creditors suffered some unjust cost, such as unpaid bills or court judgments.

Some of the most common factors courts consider in determining whether these requirements are met include the following whether the corporation failed to follow corporate formalities, whether the corporation was improperly capitalized (i.e., if the company never had sufficient funds to operate on its own), and whether a small group of closely related people hold complete control over the company. Because of their size and business practices, startups and other small, closely held companies are particularly prone to losing their limited liability status under this framework. Smaller companies are less likely to follow corporate formalities and, more importantly, more likely to mix business and personal assets.

Courts often look for whether there has been commingling of corporate and personal assets in determining whether a corporation or LLC is little more than an alter ego for its owners. Commingling of assets may occur, for example, if a business owner pays personal debts using a corporate bank account or deposits checks made payable to the business into their own personal bank account. These kinds of activities should be avoided in order to keep the company’s limited liability status.

 

What Startups Should Do

To avoid these kinds of problems, there are a number of steps startup founders and owners should take, including the following:

  • Establish separate checking accounts for the business and for your personal assets, and also consider establishing a distinct business savings account.
  • Pay for business expenses only out of the business account.
  • Pay for personal expenses only out of a personal account.
  • Obtain a dedicated business credit card, and use this card to complete business-related transactions. If your business’s credit is not sufficiently established to qualify for a card, at the very least designate one of your personal cards that will be used only for business-related expenses.
  • Any money transferred to the business owner, including salary and dividends, should be transferred according to specific, formal protocols, not in an ad hoc fashion. Do not skip any intermediate steps.
  • Make a reasonable initial investment in the business so that the company is sufficiently capitalized and will not require regular payments of debts from your personal accounts.
  • Make sure that business assets and liabilities, including loans, are titled in the business’s name.

These suggestions are just a few of the steps that a business owner can take to maintain corporate limited liability status. Distinct finances alone will not protect this status if other factors, such as a complete lack of corporate formalities, are present. But keeping business and personal accounts separate is a good initial step towards ensuring that some of the key advantages of the corporate form, including limited liability, are actually available.