Director Governance and Insider Transactions

There's a moment in the emergence of the start-up, after some critical mass of investors and employee-owners have bought in, when the founder's interests start to materially separate from the start-up's.FN1

While corporate conflicts of interests are relatively routine, start-ups are somewhat unique in that the persons who hold a large if not majority stake in the company - the founders - typically also comprise the centralized authority - the Board of Directors. Thus, the conventional guard against conflicts of interests - investing decision-making authority in "disinterested" directors - is infeasible. There are no or not enough disinterested directors to vote.

As a consequence, decisions by the start-up's Board often lack the benefit of the business judgment rule (which requires plaintiffs who subsequently sue to prove the Board acted in bad faith - proving negligence or unfair terms is insufficient).FN2 Instead, courts will apply a generalized fairness doctrine as the standard of review of Board actions, a doctrine which presumes that the conflicted directors acted unfairly and places the burden of proof on directors to show fair dealing (and in the case of valuation of the company, fair value).

Many transactions before a start-up Board's consideration raise theoretical conflict of interest issues, so the risk is widely applicable; however, as a matter of practice, the most salient risks occur during a dilutive financing. The "insider led" (i.e., director or major/controlling investor led) down round is particularly risky because such investors have the ability to set the investment terms (so are any financing events which provide some liquidation return for investors (where, for example, insiders might have more information regarding a potential liquidity event than the other shareholders)).FN3

The recommended precautions to guard against subsequent claims of conflict of interest (i.e., suits by disgruntled stockholders) can get pretty technical and each set of facts requires individualized scrutiny, etc., however, two action items will generally reduce the lion's share of exposure:

First, secure approval from all stockholders with full disclosure of terms (with particular detail on the benefits of the financing terms to the controlling investors (i.e., the Board members) and factors that would adversely affect or impact non-participating shareholders) even if such approval is not technically required under previous financing agreements.

Second, specifically in the context of financings, allow for equal participation in, or a rights offering that accompanies, the financing, even if, again, the previous financing documents do not demand it. Shareholders (and sometimes, to a lesser extent, employees with vested options) should be permitted the right to participate in the financing on or participate on substantially the same terms as the inside investors.

FN1.
 The manifestation of this separation takes myriad forms, but can include, just by way of illustration, both small events (the use of start up assets for both personal and business purposes or transactions with third parties (leasing of software, rental space, etc.) in which the founder has some business stake) and large (authorizing or not authorizing an acquisition in order to keep one's job).

FN2.
California and Delaware statutory laws protect a board of directors so long as the relevant transaction was either (i) approved by a vote of disinterested directors or special committee, (ii) approved by a vote of the disinterested stockholders, or (iii) even in the absence of approvals, the transaction was fair and reasonable at time it was authorized by the Board. The benefit of the approvals, note, is that the transaction doesn't have to be fair and reasonable, so long as the proper approvals were secured. Note further, however, that under respective state laws, failure to secure approvals coupled with a finding the transactions was not fair and reasonable leads to PERSONAL liability (which is a serious matter given that most private start ups do not carry D&O insurance).

FN3.
The disclosure issue is a relatively transparent issue of insider trading but the self dealing issue is slightly opaque. Another way to see it is to consider how readily an insider led "down round" can be used as a pretext to dilute other stockholders. Directors and majority stakeholders would always profit from a down-round in which they but no one else participated, because in the absence of any true arms length negotiation they could price the round at a very low price, invest a small amount of capital and come out with a huge portion of the equity.

The Application of Rule 144 to Start-ups

SEC Rule 10b-5 (fraud) and Regulation D (disclosure requirements) are the federal securities laws people generally pay attention to, principally because when things go wrong (e.g., a start-up fails/never gets market traction), investors look at them for cause to sue.

Rule 144 by comparison is less commonly leveraged as a litigation tool and accordingly, a bit boring. However, because Rule 144 is structurally embedded in the narrative of any venture financing it's useful to understand how it works.

In essence, Rule 144 articulates the statutory requirements for reselling stock received from a company. The relevant context is this: when an investor/founder/employee receives equity in a start-up, it's almost always pursuant to SEC exemption Regulation D (and the attendant state statute); such exemption making it unnecessary for the issuing company to provide otherwise obligatory (and burdensome) disclosures and reports to the investor/founder/employee. The exemption is allowed because such transaction involves a "private" (not generally available to the public) sale to an investor/founder/employee who presumably has enough information and sophistication not to be swindled.

However, once the issuer/founder/employee receives the equity, the SEC has a new worry: that he's not an investor but a bag man. An underwriter. A stooge. The conduit through which the company sells securities to the public absent registration. Hence, Rule 144.

Rule 144 generally applies to "restricted securities" - definitionally interpreted to mean securities that have been issued pursuant to a private and unregistered transaction (such as start up stock).FN1 Rule 144 is a non-exclusive "safe harbor": it sets forth the circumstances by which these restricted securities (often referred to as legend stock (because the certificate received by investor will bear a legend indicating the stock is subject to restrictions), restricted securities or 144 stock) may be sold in the public market without risk of violating federal securities laws.

Historically, law suits in connection with the re-sale of stock in VC or angel funded companies have been uncommon events. Moreover, under the terms of most equity issuances to investors/founders/employees, usually manifested in an Investor Rights Agreement, investor/founder/employee is prohibited from reselling CONTRACTUALLY.FN2 Usually, the terms prohibit resale absent company's permission and subject to the presentation of a legal opinion or SEC "no-action" letter (or equivalent) that the sale is exempt from securities laws.

As a consequence, even though as a technical matter of federal securities laws an investor/employee/founder could (at least in some cases) legally sell his restricted stock pursuant to Reg D (or some equally applicable exemption from federal securities laws), his contractual agreements with the issuing company would probably prohibit it, which means, for all practical purposes, the investor/founder/employee is stuck with the stock until the company reaches some liquidation event - namely an IPO or merger with a public company.FN3

In the event of such an IPO or merger, Rule 144 comes into issue. In both an IPO and a merger, trading of stock acquired before the IPO or merger remains restricted (save some exceptions for shares issued pursuant to Rule 701 (pursuant to a stock option plan)).

Rule 144 has two main requirements in the event of resale after an IPO or merger: that the reseller have held the stock for a certain period prior to the resale and that the reseller only sell a certain amount of stock (known as a selling volume limit).FN4 The former imposes a 6 month (previously 12 month) holding period (that begins when the subject shares are fully paid for) and the latter sets the selling volume limits at greater of 1% of outstanding shares or average reported weekely volume of trading during preceding four weeks (meaning, once the company's stock post IPO or merger is being traded on a public exchange, then the seller's sales of stock can only comprise a small percentage of the trading of the company's stock). Once these requirements are satisfied, the reseller may request the company remove the restrictive legends on his stock certificates, sell to the open market and start living the dream.FN5

FN1.  Rule 144(a)(3) identifies what sales produce "restricted securities." Typical examples are VC investments, employee stock option plans, and compensation for professional services. It should be mentioned that Rule 144 also governs "control securities" - defined as those held by someone (such as a director or large SH) in a relationship of control with the issuer (the difference here is one of rationale: the restriction is based on the seller's status (in fact the underlying stock he owns in fact could be registered); for example, if he can or does control the company issuing the stock.

FN2. The company imposes the contractual limitation because the SEC will hold the company responsible for violating the 1933 Act if the holder transfers when he should not.

FN3. The other reasonably foreseeable scenario is a resale to a large bank or bank-like fund via Rule 144A. Rule 144A permits resales of the restricted securities to a "qualified institutional buyer", provided that such QIB be provided certain financial and other information about the issuer. QIB includes any institution that owns and invests on a discretionary basis at least $100 million in securities of nonaffiliated institutions, except that a bank or savings and loan must also have an audited net worth of at least $25 million, along with certain mutual funds and registered dealers. 

FN4.  In addition to the holding period and volume limitation, there are three other basic requirements: 1) Information about the company must be publicly available for at least 90 days before resales  (this generally means the issuer has complied with the periodic reporting requirements of the Securities Exchange Act of 1934), 2) the stock must be sold through brokers or directly to a market-maker (such as an investment banker), and 3) a Form 144 must be filed with the SEC at the time of any sale, with an exception for sales of fewer than 500 shares for less than $10,000.

FN5. It should be noted that contractually (via the purchase agreement and related agreements), most investors/employees/founders are prohibited from selling off their shares immediately after an IPO or merger anyway, via a mechanism called a "lock-up", which varies but usually lasts for about 6 months.

The Problem of Anonymized Data

Over the past three or so years both OK Cupid and Facebook have published a great deal of aggregated, anonymized data for, let's say, the enlightenment and mirth of society at large. Facebook shared information on how "happy" users seemed on certain days and OK Cupid shared (as it has been doing) some interesting information about dating preferences of certain groups. 

The LA Times blog has been one of the few voices to point out the privacy implications of these data shares, saying, "Despite its silly name, the Gross National Happiness indicator is creepy. We're in there."

Several events - most notably the promotional (and seemingly innocuous) publication by Netflix of data regarding movie preferences of its customers - have revealed fundamental security problems with so-called anonymized data (Netflix was sued in 2009 in connection with this and settled out of court). By some accounts, the widely used concept of "personally identifiable information" on web site privacy policies - which by implication suggests the existence of information about you that is somehow not "personally identifiable" - is misleading. There's been a spate of studies finding that people with PHDs have the capacity to "re-identify" or disambiguate so-called anonymized data. The underlying principle is that ostensibly random data points (such as a birth date and a zip code) can be tied to a specific person if coupled with some other set of information (publicly available or readily mined, etc.) It's not clear that data anonymized in accordance with best practices is easy (cheap) to re-identify but it is clear that it can be done.

Thus, a quandry for businesses that want to sell or otherwise profit from anonymized data. U.S. laws and state laws with respect to consumer data privacy don't forbid it. In fact there are hardly any restrictions whatsoever on properly de-identified data, even if the data is being sourced from financial or health-related data or data concerning children (laws are more restrictive with respect to these categories of data). Further, as most privacy policies on web sites inform users that "anonymized" data may be shared with third parties, in most circumstances users have a reasonable expectation (due to a privacy policy or otherwise - provided they had proper notice and consent of the privacy policy) that their data might be released in such a form and hence would not have contractual cause to sue in the event it ever was. Relatedly, one would not expect the FTC (or analogous state agency) to prosecute a company for sharing anonymized data (on grounds of misleading consumers about data collection and sharing practices) so long it took precautions to ensure the data couldn't be easily re-identified.

But this is uncertain. The lack of case law at this point makes it difficult to clearly define what constitutes a) proper precautions (if any) for anonymizing data and b) reasonable consumer expectations as to the same . By way of example, The California Supreme Court recently held, for the first time, that a ZIP code - standing alone- qualifies as "personally identifiable information." See Pineda v. Williams-Sonoma Stores Inc., No. S178241 slip op. (Calif. Feb. 10, 2011).

Share Calculation on a "Fully-Diluted Basis"

Most seed or series financings calculate the preferred stock share price paid by the investor on a "fully-diluted basis."FN1 This sounds like math but really it's basic, macro-level accounting.

The underlying principle is this: the determination of how many shares the investor receives for the money he's investing is a proxy for something more crucial: the investor's percentage ownership of the company.

The investors have an incentive to capture as much percentage ownership as possible and thus have an incentive to capture as many shares as possible. "Fully diluted basis" means that the investor's proposed percentage ownership of a company be calculated against the absolute TOTAL number of shares outstanding in the company - the "basis".

The reason this matters, and why the terminology is often embedded in legal documents, is that often at the time of a seed or series financing there is outstanding stock that gets overlooked. This stock has been effectively but not technically issued - in the form of unexercised stock options, warrants, convertible debt and the like. The calculation of what's included in the basis determines who will assume the future diluting effect of any stock that is not exercised at the time of the financing (but almost surely will be at a later date).

If the basis calculation includes unexercised stock, then at the time of the financing the existing common stock holders (i.e., founders) - but not the investors - are, in effect, diluted. If the calculation doesn't, then when the stock is eventually exercised, all the existing stock holders, including investors, share pro rata in the dilution effect. For example:

Pre-financing Company has issued 5 shares of common stock but also has unexercised debt and stock options convertible into a total of 3 shares of common stock. Investor wants 50% ownership. If basis does not include the unexercised securities, investor gets 5 shares. If basis does so include, then investor gets 8 shares (for the same amount of money invested).

So, that's the concept. Mechanically, the calculation works on the level of the share: the larger the basis the less the investors will have to pay per share of the preferred stock. This is a function of the oft-cited formula: per share price = pre-money valuation / total outstanding shares.

FN1. “Fully-diluted” capitalization typically means (i) all issued (outstanding)  common stock, (ii) all issued (outstanding) preferred stock, (iii) any issued (outstanding) warrants, (iv) all issued (outstanding) options, (v) options reserved for future grant, and (vi) any other convertible securities. In essence, the only category of stock that is not counted in this fully-diluted capitalization number is the stock that is "authorized" in the Articles of Incorporation but as yet not issued.

The Crowd-Funding Problem

Crowd-funding - raising capital through a large network of individuals each providing a small investment that collectively adds up to a large sum - seems a natural evolution of the start-up financing model. The problem is that it's illegal. FN1

Securities laws generally require the "registration" of the sale of any securities, such as the common or preferred stock offered in seed or Series A financings, requiring technical compliance with a number of registration rules, including, among other things, the disclosure of vast quantities of information to purchasers and the preparation of audited financials. All of this is super expensive. The economics of crowd-funding don't allow it.

Of course, there are a number of exceptions to the registration rules, the most notable being the "private placement" exemption, originally curated under Section 4(2) of the Securities Act and later broadened under Regulation D. Most seed and series financings are conducted pursuant to Section 506 of Reg D, which permits sales of securities to "accredited" (i.e., wealthy) investors without costly disclosure documentation.

The whole idea of crowdfunding of course is that you shouldn't have to own a polo pony and a Porsche to make investments in start-ups, which moves us to Section 504 of Reg D, which does not impose an "accredited" investor requirement.FN2 The big problem here is that Section 504 still prohibits a "general solicitation" or advertisement of the offering to the public at large. 504 requires a pre-existing, substantive relationship between an issuer (or its broker-dealer) and the investor(s), and this is why 504 is relied on almost exclusively for investments from close family and friends (and not say, from half-known acquaintances you're connected to on linkedin).FN3

Accordingly, absent some special story, neither 504 nor any other federal exemption provides safe harbor for the crowd-funding structure. The only legal way (for now) to raise capital through crowd-funding would be to go through the full registration process at both the federal and state levels, which isn't economically tenable.FN4

FN1. This blog post presumes a conventional financing by a corporation and not a creative alternative (such as a revenue sharing plan, giving investors a flat payment or investors being involved in the day to day running of the business). Although be aware that Section 30(b) of the Exchange Act may prohibit transactions which are designed to evade the Exchange Act.

FN2. Note than 504 expresses a federal securities laws exemption. State securities laws impose their own requirements and exemptions. Although state securities laws tend to track federal requirements, in some cases, state laws are more restrictive.

FN3. Relatedly, for any entrepreneur interested in building a crowd-funding platform/web site, there is the broker-dealer problem. Section 15 of the Securities Exchange Act requires that anyone acting as a "broker-dealer" - which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others" - must go through its own expensive and lengthy registration process. Whether a crowd-funding platform constitutes a "broker-dealer" is a technical question and the relevance of past precedent (comprised of almost exclusively of SEC no-action letters, etc.) is hardly clear. However, it's probably safe to say that the more any such platform/web site is promoting sales of securities (telling an investor about some company, trying to encourage investment) and the more the incentive the platform/web site has to make such sales happen (receiving a commission), the more the broker-dealer requirement is implicated. 

FN4. If history is any indication so long as there is significant market interest in a particular kind of transaction and no one is being taken advantage of, the SEC will make adjustments to the law to allow a market in such transactions to develop. Being a first mover in such a market involves without question legal risk but it would seem anyone who waits until the SEC makes compliance issues crystal clear will lose out. Such is the dilemma.

409A Constraints on Stock Option Grants

Hot tax code insight of the week!FN1 Section 409A of the Internal Revenue Code requires that companies issue stock options at a strike price that reasonable approximates FMV.FN2 This has one of two practical consequences:

              i) start-ups issue restricted stock instead (or an analogous exemption (any property (such as stock appreciation rights) subject to Section 83 is okay)), thereby bypassing 409A; or
              ii) start-ups go through the (somewhat expensive) process of establishing a FMV (in compliance with 409A) prior to issuing in stock options.FN3

Here's the background: under the previous regulatory framework (governing things during the early '00s), stock options could be issued fast and loose, often according to some vague formula (like 1/10 of the value of the last financing's share price). This allowed rich guys to defer huge portions of their rich guy salaries into the future.

So the IRS enacted 409A, which governs all deferred compensation plans and agreements entered into, or vesting after, January 1, 2005, and requires that i) stock options are issued at FMV and ii) the FMV must be determined using “reasonable application of a reasonable valuation method.” The IRS has provided guidance that the determination of reasonableness (an inherently circumstantial standard) will presumptively be satisfied by either of the two following approaches:

1) Independent Appraisal. An independent valuation by qualified experts using standard methods recognized under the IRS Code.

2) Illiquid Start-up Appraisal. Certain private companies (in existence less than 10 years and not anticipating an IPO in the next 6 months nor a merger in next 90 days (among other things)) can rely on valuation by a person (including an employee) with significant knowledge or training in performing such valuations. (Go here for a detailed discussion of the requirements).

The presumption of reasonableness is rebuttable only upon evidence that the method or the application of such method was "grossly unreasonable" (there's no official guidance on what this means).

Such valuations last for 12 months absent any intervening events that would materially and reasonable affect FMV. Failure to comply has a number of consequences, the most salient being that employees will be subject to taxation at each vesting milestone plus a 20 percent penalty, and potential interest.

Most companies engage in precisely the kind of appraisal required by 409A at each financing event but if such financing was more than a year in the past and the company is short on cash it is probably better off issuing restricted stock rather than stock options as incentive equity.

FN1. A character in David Foster Wallace's novel Pale King (set in an IRS office in the Midwest) describes tax compliance as "boredom beyond any boredom he’d ever felt."

FN2. More generally, 409A applies to any legally binding right to deferred compensation (any agreement, plan or arrangement that provides for a deferral of compensation, even if such compensation is subject to restrictions (such as vesting)).

FN3. The cost for valuation appraisal varies, but will probably come in between $5k and $25K.

83(b) Tax Elections

83(b) of the Internal Revenue Code is a niche tax-savings allowance for entrepreneurs and the tech geeks they hire (not the technical definition).

83(b) implicates the following: if you're a founder, an early employee or otherwise a recipient of RESTRICTED EQUITY ("equity" = stock or LLC units, etc. but NOT options (which aren't recognized as property by the IRS until exercise (but note that some options plans allow for early (prior to vesting) exercise and these options would be "restricted")); "restricted" = restrictions that lapse, typically due to vesting) in a start-up, then, presuming you'd rather pay less taxes than more, you should notify the IRS IMMEDIATELY upon receiving such equity (by filing an 83(b) notice).FN1

According to 83(b), if you voluntarily and timely (the 30 day(!) deadline is notoriously inflexible) notify the IRS that you've received such restricted equity, then you assume immediate income tax liability on the difference between the FMV of that equity (usually not much about zero (i.e., par value) in the inception stage of a start-up corporationFN2) and the amount you paid for that equity (usually par value or zero, as negotiated). At the future date when you later sell that equity, then you pay capital gains tax on the appreciation from the original date of purchase.FN3

If you fail to make that initial notification, you are taxed instead at each future vesting milestone (typically, at the year cliff and then monthly/annually for the next three years). This may have significant implications. For example:

Joe Founder is granted company stock at some nominal purchase (probably par value) price (say $0.01 per share) with a FMV of $0.001 per share. The stock has four year vesting with a one year cliff. Joe doesn't file an 83(b) election. At the end of the one year cliff, the stock having appreciated to $1.00/share, Joe recognizes and must taxes on $0.999/share of income for that year. As the remaining stock subsequently vests each year/month (whatever each vesting milestone is), Joe again recognizes and must pay ordinary income taxes on "income" (even though the stock is presumably illiquid and Joe can't sell it) equal to the difference between the (presumably rising) FMV of the newly vested portion and the original $0.001/share purchase price. Moreover, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.
If Joe had made an 83(b) election, he would not recognize any income as the stock vests, because the 83(b) election forever freezes the income calculation as of the original grant date.

It almost always makes financial sense to file the 83(b), however, it does depend on the underlying value of the equity at the time of issuance and future prospects. In the odd circumstance that the equity at the time of grant has a material FMV AND there is a material risk that it won't increase in value (because, say, the start-up fails), you've accelerated your tax liability without receiving any benefit.

FN1. The mechanics of filing the 83(B) notice are surprisingly informal. While forms exist to facilitate the process, none are issued or required by the IRS. A handwritten note sent to your local IRS office (the full list of information that needs to be provided can be found here) would technically suffice. What really counts is the 30 day filing period. There is no extension available, or any simple cure for missing the deadline.

FN2. Note that Companies (via the Articles of Incorporation) typically assign a "par value" to stock (in some states its a requirement), which prohibits the Company from issuing stock to anyone at a price below that par value (i.e., no free stock).

FN3. The default Section 83 rule is that income (the difference between FMV and the price paid) on restricted stock is not recognized until the restrictions lapse. This rule is actually intended to benefit the taxpayer - the unique economics of start-ups undermine the intention.

Vesting: Single versus Double Trigger Acceleration

Most vesting provisions for restricted stock or stock options ("incentive equity") include acceleration provisions as insurance of sorts for employees and founders ("service providers").

The underlying concept is this: incentive equity typically vests on a four year schedule (as per market standard). Absent acceleration, if an event were to occur before the end of those four years - such as a sale of the all the assets of the company, a merger, or an IPO - that resulted in the service provider's termination (or resignation with good cause), then she'd lose the benefit of her expectation. She'd lose the right to the portion of the equity that hadn't vested - which happens to be precisely what certain interested parties (investors, new management/ownership, etc.) would like to see happen (because unvested restricted stock effectively vanishes and the rest of the shareholder base benefits proportionately from the reverse dilution) and why termination is such a real risk.FN1

Acceleration triggers guard against this. "Single" trigger refers to the automatic vesting of any unvested incentive equity upon the said event. "Double" trigger requires two events before the automatic vesting - not just the merger but the actual termination or early release of the service provider.

A common acceleration agreement averages the two triggers: combining 25% – 50% single trigger acceleration with 50% – 100% double trigger acceleration. Fairly convincing arguments are made that double trigger acceleration best balances the interests of service providers with interests of the company (entire shareholder base).FN2

It's all pretty straightforward stuff. One point to note: the trigger should run for a period of time before as well as after the transaction that constitutes the trigger event (or otherwise be constructed to to avoid any preemptive house cleaning before the transaction is done).

FN1.The assumptions behind the logic of what interested parties will want in the event of a merger/sale can get speculative but generally, regardless if the acquirer's interest is in company assets or people and /or if the equity at issue is unrestricted stock or stock options (Stock options, in contrast to unrestricted stock, "return" (to the extent they ever left) to the pool of stock reserved for employees (usually 5%-15% of the outstanding stock)), acceleration clauses will likely decrease the purchase price. To the extent there are provisions in place (such as unvested equity) that incentivize service providers to stick around the acquirer will see and presumably pay for that additional value. Although the acquirer could separately create (and pay for) an employee/management retention mechanism as part of the deal, that payout would (for the rational acquirer) carve-out from the overall deal value, reducing the consideration allocated to the target company stockholders. Note here the conflict of interest between VC investors and the service providers being bought out).

FN2. A variation suggested here is single trigger plus a minimum X (say 12) months of service before the out.

Warrants and Employee Stock Options

Employee stock options and warrants (both give the holder the right to purchase a security at a set price, usually referred to as the "exercise" or "strike" price) function in about the same way but have two basic structural differences (which explain why warrants tend to go to advisor/investor types while options go to employees).FN1

First, from the issuing company's perspective, warrants behave like a financing (albeit with no initial servicing costs like dividends or interest) whereas stock options behave like an employee incentive. This is because although both warrants and stock options are derivative instruments (the value is not in the thing itself but in its derived value from an actual security (i.e., stock)), the stock ultimately issued for a warrant is newly issued stock - prior to the issuance it did not exist - similar to the way new stock is issued to VCs when they make an investment in a start-up.

The stock issued for an exercised option, by contrast, is derived from the previously existing "stock option pool" (which usually comprises somewhere between 5-20% of the outstanding (i.e., already issued) stock of a company).FN2 Thus as a consequence, the exercise of warrants (like the issuance of preferred stock in a seed or series financing), necessarily dilutes existing shareholders (which is a significant event for the company). The exercise of stock options, by contrast, just consumes some portion of the shares set aside for the stock option pool.

Second, from the holders' perspective, a stock option is less valuable because it is subject to a set of restrictions.FN3 While in most cases a warrant implicates the right to purchase the underlying stock at any point in the future at the holder's reasonable discretion (and in some cases the right to transfer that right), a stock option i) can almost never be transferred, ii) is subject to a vesting period and iii) has a limited exercise period (meaning, the stock option, once fully vested (usually four years down the road), has to be exercised within a few months or a year after vesting).FN4

FN1. This discussion solely addresses the common use of employee stock options and warrants in a start-up context. Stock options and warrants can be manifested in myriad ways - practices outside the U.S. in particular add additional complexity.

FN2. If you get fancy, you can argue that if a company does not presume the existence of a employee stock option pool, the relevant distinction between warrants and employee stock options gets exceedingly small.

FN3. Usually. While employee stock options are highly standardized, the terms of warrants are highly customizable.

FN4. The tax implications of warrants and employee stock options depend on the circumstances. As a general matter, warrants are a taxable event upon issuance but options are not, provided, however, that the warrants were issued as part of a financing while the stock options were issued in exchange for future services. If the warrant is compensatory, taxability is deferred under section 83 until exercise.

Trade Libel

The spectacular growth of user-generated content via twitter, Facebook, Yelp, wikis, video-sharing sites and anything else designated Web 2.0 has given new valence to online character and trade assassination and the legal issues (primarily, defamation) that go along with it.

So far website owners haven't had much to worry about. Under §230 of the Communications Decency Act ("CDA") online service providers (anyone offering a product that allows users to interact and collaborate with each other in a social media dialogue) are generally immune from lawsuits that seek to hold them liable for speech posted by their users. As a consequence the majority of attention in this field has gone to the issue of personal libel and the the liability of individuals like Courtney Love and fashion bloggers who end up tweeting or blogging allegedly scurrilous things about personal enemies.

Trade libel (or commercial disparagement), however, may quietly become a bonafide risk for companies operating in the social media space.FN1 Several court decisions, most notable the Roommates.com case, indicate that immunity under CDA is not absolute.

The risk here is restricted to companies that can be said to have reasonably contributed to or encouraged unlawful conduct by its users. Fair Housing Council of San Fernando Valley v. Roommates.Com (2008) 521 F.3d 1157 (which involved an Internet website that facilitated postings inquiring about the race of a prospective renter) is the prevailing guide on the matter, the court having said (albeit in dicta) that where the service provider “solicits” or otherwise actively participates in generating illegal or defamatory content, then the immunity provisions of the CDA may not apply.

Social media is new enough as a business practice that the relevance of Fair Housing is at best speculative and, further, the practical risk of trade libel may be minimal to most social media companies, however, to the extent a company is specifically modeled to provide a forum for consumers to criticize or complain about businesses (see e.g., ripoffreport.com, complaints.com, etc) and to promulgate such criticisms and complaints, legal exposure is there.

FN1. Trade libel in California is defined as an "intentional disparagement of the quality of property, which results in pecuniary damage to plaintiff." Erlich v. Etner (1964) 224 Cal.App.2d 69, 73, 36.

The Cumulative Dividend

In connection with term sheets and the raising of capital, dividend preferences (a dividend is an annual distribution of profits to shareholders, generally paid in cash or stock) are rarely a meaningful negotiating point, for three main reasons.FN1 First, investor-backed start-ups rarely generate profits early on, so there's probably nothing to distribute and the issue is moot. Second, even if that doesn't prove the case, the founders understand any profits should be re-invested in the growth of the company. Third, unlike, say, private equity guys (who are investing big money (usually more than $50MM) with lowered expectations for return multiples on invested capital), VCs and angels are less focused on percentage annual yields than the long term multiple they'll get back from the investment. "The juice," as one commentator says here, "from the dividend is nice [for VCs], [but] it doesn't really move the meter in the success case".

What you get in 10% or so of financings,FN2 however, is investors asking for dividends that accrue and accumulate from one year to the next. Such dividends are called "cumulative' and are akin to roll-over minutes with a phone plan. To the extent a dividend is not declared (by the BoD) during a particular year, the dividend is carried forward to the next year. (Non-cumulatives (“when, as and if declared” dividends) do not carry-over).FN3

The argument from investors is that the cumulative dividend is necessary as reasonable down-side protection to guarantee a minimum annual rate of return on investment (often in the range of 5-10%).FN4

This wouldn't have an immediate impact on the company's cash position but if the investment remains outstanding for an extended period the effect could be large (and also generally doesn't reflect well (to future investors, potential lenders (i.e. creditors, etc.) on a balance sheet since the dividends are liabilities).

The move for the company is to concede to cumulative but establish conditions that ensure the cumulative dividends act as a protective device rather than a windfall. Allow unpaid accumulations to factor into the liquidation preference (or maybe even the redemption price) but not the conversion price (the rate at which the preferred stock converts into common stock).

The former scenario is not only the most common formulation - giving investors an increased share of the proceeds in the event of a sale - but the one that best serves to return investors some portion of their money back in the event the company needs to be sold on the cheap or liquidated due to insolvency.

The latter scenario, however, could have an enormous impact in the case of a successful company exit (e.g., an IPO) because it increases the investor's pro rata entitlement to proceeds and should be resisted for this reason (absent a cap to the investor's return or some other special story).

FN1. Language in term sheet in connection with dividends will read something like, "Dividends: The holders of the Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [x%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of the Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis.”

FN2. 10% number is from Fenwick and West, reporting in 2010.

FN3. If the non-cumulative is not declared by the BoD at year's end, it is extinguished and begins accruing anew the following year.

FN4. The logic of this can be deceptive. In a way it seems reasonable for the investors to receive some kind of interest return (in the form a dividend) for the time value of their investment. But note that investors have (almost always) an uncapped upside participation right. That's what they're buying: an equity instrument not a debt instrument.

Stock Option versus Restricted Stock Awards

In most scenarios it benefits both the company and employees to give employees equity in the company. The employees are inspired by a sense of ownership and the company saves some cash. The trickier question is one of form: does the company offer stock options or restricted stock?

The mechanics of stock options are pretty basic: the company grants to the employee a call option to purchase - at a discount - X number of shares of the company's common stock. The discount is called the "exercise" (or "strike") price. Under this scenario, on the date the employee wants to sell and profit from his stock award, he purchases up to X number of shares and then turns around and sells the shares at a (presumably) much higher market value price and pockets the difference.FN1

Restricted stock, by contrast, is a straight gift of stock.FN2 The employee does not need to outlay any money. The "restricted" part is the caveat: the company retains the conditional right to purchase the stock back from you at some super cheap price - and usually this right expresses itself through a vesting requirement (i.e., although the stock is a straight gift it requires the employee to stick around the company for a certain period of time (market standard is 4 years to receive the full amount, with 1/4 of the total becoming available each year)).FN3

These structural differences implicate three main issues.

First, restricted stock gives the employee real as opposed to theoretical (in the case of options) value, and such real value is taxable to the employee upfront (stock options will not be taxed until the option is exercised (if ever)).FN4 So long as the initial value of the stock is low (such as in a start-up situation) this is probably to the advantage of the employee. The payment of that initial income tax aside, the employee won't pay any taxes until he sells the stock, at which point, so long as certain holding requirements are met, the tax will be capital gains rather than (historically higher) income tax.

By contrast, stock options will almost always result in ordinary income to the recipient when exercised (at least in the typical case where the underlying stock appreciates prior to exercise of the option).

Second, the grant of stock options require as a predicate the determination by the company of the "exercise" price. Because Section 409A of the Internal Revenue Code requires that the exercise price must be equal to (or greater than) the fair market value of the underlying stock as of the grant date, the company must coordinate (by the time of the grant) (i) an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” a valuation of a person with “significant knowledge and experience or training in performing similar valuations” (who could be a company employee), which costs time and money.

Third, stock options give employees only the opportunity to benefit from the increase in the company’s value. If at a future date the market value of the shares drops beneath the exercise price per share (which is fixed to the time of the grant) then the stock options will be worthless.FN5

FN1. Two caveats here. First, in most cases, stock options are qualified/restricted by "vesting", which means that the right won't actually be triggered until a future date. Prevailing standards put the right to purchase 1/4 of the shares at the 1 year anniversary of the start date, 1/2 the shares become available to purchase at the 2 year anniversary, 3/4 on the third and all the shares on the 4th anniversary. In addition, most vesting provisions include acceleration clauses which accelerate vesting in the event of certain transactions (usually an IPO or acquisition). Second, more sophisticated service providers may exercise the option to purchase their stock before they intend to sell (because, essentially, the appreciation prior to exercise is taxed as income and the appreciation post exercise is taxed as capital gain).

FN2. Both stock options and restricted stock are sourced from the "incentive equity pool" of common stock reserved for employees. In most funded start-ups this pool will represent between 5-15% of the issued stock.

FN3. Restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets.

FN4. In most scenarios the employee will want to file here what is termed an "83(b) election" with the IRS so as to be taxed immediately upon the grant for the value (if any) of the restricted stock. If he doesn't make that filing within 30 days of the grant then he will be taxed incrementally over time as the restrictions to the stock disappear (i.e., the stock vests) - which can be prohibitively unaffordable if the stock appreciates significantly (yet remains illiquid).

FN5. Stock options have fallen out of favor during the last (markedly volatile) decade or so precisely due to this possibility.

Contracts and Electronic Signatures

It's unnecessary to sign commercial contracts with a pen but the practice persists.FN1

The federal Electronic Signatures in Global and National Commerce Act, enacted in 2000 (note the federal law does not apply to intra-state transactions) and most states (due to the Uniform Electronic Transactions Act being adopted by most states) allow electronic signatures (or signature via an electronic record) for the valid execution of a contract. Neither law imposes a rigid format on the signature, so the fact that there isn't a “digital signature” - i.e., something like "/s/ Firstname Lastname" - doesn’t affect the fact that you can be deemed to have signed a contract by email correspondence.

Manual signature remains the custom in part because manual signature is a pretty effective authentication of the signator's willful and knowing acceptance of the terms of the contract (because a manual signature is personally identifiable in a (somewhat) unique way). Thus, reliance on an electronic signatures demands i) some proof of identity - something to verify that the putative signator's brother/aunt/stalker didn't send the electronic signature and ii) something to indicate that the signator knew what he was agreeing to (which is why when you go to amazon or bestbuy.com or wherever they require you to scroll down through terms and conditions or check some box (or an equivalent)) before you click through.

To the extent there is a mechanism in place that addresses these two issues statutory requirements will be satisfied. In most cases, verbal confirmation followed by an email from the signator enclosing the signature page with his electronic signature (first and last name) should suffice.

The effect of this, beware, cuts two ways. First, it means the process for executing a contract has been simplified. Second, however, it means e-mail correspondence may have unintended results. A vaguely worded or poorly thought through email can trigger all the responsibilities and obligations of an agreement. (Note that this could happen AFTER the agreement has been executed.FN2).

FN1. Note that certain contracts, such as trusts and certain real estate contracts, still require old school, manual signature and probably will for a good while longer.

FN2. E.g., in Stevens v. Publicis, S.A. (2008) the New York State Supreme Court held that a written agreement could be modified (i.e., amended) by e-mail correspondence.

A Primer on Copyleft and Related Open Source Issues

According to the conventional licensing model, holders of copyrighted software grant proprietary licenses to 3rd parties to use the software, usually in exchange for money. Such a license restricts how the software may be used (and modified or distributed) and if the licensee exceeds those restrictions the licensor may bring an action of infringement.

The so-called Copyleft model removes most of these restrictions but does so without making the software public domain (where users could modify then copyright such works, thereby undermining the effort).FN1 Copyleft maintains the licensing framework but aggressively enlarges the scope of the license on a very specific condition: use, modification and redistribution of the software (modified or not) is unlimited so long as this same allowance is given to all future licensees. The exact wording of the original license must be preserved each time the software is modified and distributed. Whatever rights inhere in the original license are there for perpetuity. This mechanism is variously referred to as a "Reciprocal Grant, "Viral License" or "License Inheritance."

As a necessary corollary to or function of the inherited license, all source code (read-only programs are insufficient) must be made accessible to future users (so it may be modified).

These requirements don't prohibit commercialization of the software. Copyleft does not necessarily mean "free." While you cannot charge for a proprietary license, you can charge for each copy or for warranty, support, services, etc. Because selling individual copies is rarely profitable (since the seller cannot by virtue of the sale control/limit what the buyer does with the source code thereafter - like give it away for free), the value of copylefted software to corporate enterprise typically inheres in the sale of products or services in which the copylefted software is embedded.FN2

FN1. In addition to copyleft there are so-called "academic" licenses which comprise with copyleft the two main groups of open source licenses.The Gnu Project's General Public License (the GPL) is probably the best-known and most widely used copyleft license.

FN2. The chief risk is this business model is the inadvertent surrendering of ownership to proprietary software. Determining what is a "derivative work" can be an uncertain inquiry (at least in part because of limited judicial interpretation with respect to the enforceability of copyleft licenses) and thus where the open source software is mingled/bundled with proprietary software, it's possible the proprietary license will be deemed to be a derivative of open source and therefore not protected by copyright.

Anti-Dilution: Full Ratchet Versus Weighted Average

There are two principal approaches to anti-dilution provisions: the "Full Ratchet" and the "Weighted Average." These concepts tend to be explained by reference to computational formulas, which work off a variable called the "conversion price". Forget that. For two reasons. First, conversion price doesn't refer to currency but instead to an arbitrary ratio (usually 1 or .3 but it can be anything), so it's confusing. Second, the computation of the conversion price/ratio, while a necessary accounting tool, is a distraction from the operational result: the reallocation of stock from the founders to the angels.

Both approaches are based on the same predicate concern: what happens to the value of the angel's investment (in the form of preferred stock (that converts into common stock upon IPO/merger)) in the event that new stock is issued (sold) to someone else at a lower price (relative to that paid by the angel)?FN1

In most investment scenarios, like real estate, for example, if the post purchase market value is lower than the price paid, so it goes. That's the risk of real estate investment. The seller wouldn't retroactively kick in extra acreage or have a guest house built on the property to make the investor feel better.

Start-up financing does not operate like that. In the event the company's value goes down post purchase, anti-dilution provisions work to re-allocate shares from the existing common stock pool to the angel's preferred stock pool to make the angels feel better. The only question is, how many shares are re-allocated?

According to the Full Ratchet approach, the answer is: a lot. In fact, full ratchet does not even care about the number of the shares per se. It just cares about the bargain given to the new investors. How much are the new investors paying per share? That's deal the angel's now want.

An analogy would be you bought 10 pants at Banana Republic for $100 then someone else comes along and buys 10 pants for $10. Under FR, you get to say, 'Give me another 90 pairs of pants.' 

It's called "Full Ratchet" because as a technical matter it demands that the ratio by which their preferred shares will be converted into common shares be retroactively decreased - "ratcheted down" - to the effective conversion ratio the new buyer is getting.FN2 The salient feature is that this occurs no matter how large or small the subsequent financing is (if - this is an extreme example - a company issues just 100 shares to subsequent investors at a $1.00 per share and the angels have 5,000 shares (for which they paid $10 per share), then under application of FR the angels gain (and the founders lose (the compensation has to come from somewhere)) an additional 45,000 shares.FN3

Weighted Average is a more measured approach. Although WA fixates on the deal the new buyers are getting, it takes into account the magnitude of the financing - how much new stock has been issued. The weight of the better deal price is balanced against the weight of the size of the purchase (similarly, the extent to which going 3 for 4 affects one's batting average depends on how late in the season the game is).FN4

There's a number of different formulas used for the calculation but as noted they aren't very intuitive so let's ignore them since the mathematical concept is straightforward. Take the post-money monetary value of the company under the old deal (just multiple the total number of company shares by the share price paid by the angel (in this case, $10 X the total number of shares (10,000 (assume 5,000 for angels, 5,000 for founders) = $100,000. This is our baseline company value under the old deal. Add to that the value being added by the new buyer - in this case $100 (100 shares at $1.00 per share). Divide (average out) that total value - $100,100 - by the total number of shares after the new buyer buys in: 10,100.

The number you get - $9.91 in this case - is going to be lower than the price paid by the angel - $10. It's an average between the old price and new price dependent on the aggregate number of shares being issued at the new price.FN2 How many shares does the angel's $50,000 investment get him now? Not 5,000 ($50,000/$10pershare) but 5,045 ($50,000/$9.91pershare).

FN1. "Original investor" and "new investor" are the two players here; "angels" is just shorthand for the former.

FN2. As noted, "conversion price" is misleading. The confusion becomes manifest in most examples you'll see - which will use $1 for the angel investment and then like fifty cents for the new investment and refer to these as conversion prices even though that is conflating two separate concepts. The conversion price is just the ratio by which preferred shares are converted into common shares, and often is 1:1 or .5:1. As a matter of fact, any investor will give a company a certain amount of money in exchange for a certain amount of preferred shares (which will have a certain price per share value that no one cares about) and THEN those shares will be deemed to convert to common shares according to a certain ratio.

FN3. Note that in these examples (and any such examples you'll see involving formulas) the calculation of the shares given to the new and old investors will be with respect to COMMON shares that the investors will eventually own. As indicated above no one really cares about how many preferred shares are being issued.

FN4. Under Weighted Average, the pants analogy works as such: There's 20 pairs of pants valued at $200 (you bought 10 for $100 and assume the founders also have 10). Add to the $200 valuation the $10 paid by the new buyers (for 10 pants). Divide $210 by the new total number of pants: 30, which equals $7. This becomes the retroactive price you paid. How many pants does $100 get you if it's $7 rather than $10 per pant? 14.28 instead of 10. Fashion for a fortnight.

Anti-Dilution Basics

Anti-dilution implicates two separate concepts, which tend to get muddled (like many words in the street glossary of financing, "dilution" has multiple meanings. Half of the expertise is being hip to the lingo).

First we have anti-dilution as the term is technically defined in term sheets, etc.: the proportional adjustment of stock ownership for a) internal recapitalizations (stock splits, stock dividends) or b) some exogenous transaction (i.e., a merger or, most significantly for this discussion, subsequent financing rounds). Within the context of the latter it means an angel's investment is protected from a future transaction in which the price-per-share is LOWER than the price-per-share they paid. It ONLY applies when the company's valuation GOES DOWN after the original investment. In VC parlance, it is "price-based protection" in the event of a "down-round."

Here's the relevant application: an angel investor has preferred stock (worth say $1.00 per share). The Company then creates and sells new stock (to say a VC) BUT at a price less than that (say $0.75 per share). Absent anti-dilution protection, there are now more shares in circulation and the average value of each share has gone down (to somewhere between 1 and .75 per share) so mathematically the angel's preferred stock has decreased in value.FN1

Anti-dilution mechanisms, however, work to give the angel FREE shares to compensate for the new stock being sold to the VC.FN2 The precise number of FREE shares depends on the anti-dilution mechanism (the most common being "full ratchet" and "weighted average" - the former is far more investor friendly) but the upshot is that the "value" of the original investor's investment will be maintained (or at least not lowered too much) despite the fact the market feels the company is performing more poorly than before (as evidenced by the lower valuation).

Note that the angel investor doesn't gain anything here. He just doesn't lose anything.FN3 Note also that this kind of anti-dilution is built (and usually only applies to "preferred" stock) into the charter documents.

Second, there are "pre-emptive rights" to participate in subsequent financing rounds - sometimes referred to as "right of first refusal" provisions - which effectively allow an angel investor to maintain his ownership PERCENTAGE by investing MORE money. In the parlance, this is the "right to maintain proportionate ownership”.

This right, as the parlance suggests, has a ceiling  - typically "pro rata" to their existing ownership. Thus, if an investor has 10% ownership of a company and there is a new round of investment the investor has the right to invest enough money to maintain his 10% ownership but no more.

Pre-emptive rights are extraordinary rights which will not be inherent in a company's charter but rather provided (if at all) as part of a separate agreement (usually called an investor rights agreement) which accompanies the stock purchase (usually in connection with a Series A deal).

Note that if an angel lacks pre-emptive rights and the company valuation in a future round of financing increases, then anti-dilution does not apply. The angel's percentage ownership will necessarily be diluted due to the additional shares being put into circulation (i.e., a new claimant to the assets and/or income of a company reduces the percentage interests of the existing claimants), however, the overall value of his shares is going UP, due to the inflow of more capital, which naturally increases (at least for a time) the value of the company and any proportionate share in the company.

FN1. This presumes the net book/market value per share diminishes as a result of the financing. It's technically possible that the price per share paid by the VC investor for preferred was for some reason unaligned with the resulting book/market value of the common. This is unlikely but goes to show that the issue of dilution depends on what criteria are used to calculate the value.

FN2. The traditional mechanism by which this happens to angels is that the “Conversion Price” that determines the number of common shares the investor is entitled to receive upon conversion of the “preferred” stock is adjusted downward (by some pre-determined calculus), such that at the time of the future conversion, this investor will receive more shares in common stock (to compensate for the share value going down).

FN3. Somebody of course is losing - the founders and employees (or anyone else who owns the common stock). These parties are being diluted twice: once by the issuance of the shares to the new stockholders and a second time as a result of the adjustment to the conversion price of the preferred stock.

Annual Meeting of Shareholders (For Start-Ups)

Most state business statutes (e.g., Section 211 of the Delaware code) require that all corporations incorporated in that state hold an annual meeting of the shareholders. The principal purpose of the meeting is for the election of directors (but any other business properly brought before the meeting may be transacted). This requirement cannot be evaded by provisions in the bylaws.FN1

There are four important caveats here. First, the shareholders do not need to actually physically convene in one location. A meeting by video or phone conference will suffice. Second, there does not need to be any special notice (absent any mandate in the bylaws or certificate of incorporation) to the shareholders so long as shareholders waive notice and consent to the holding of the meeting (note that meetings of the shareholders are usually subject to somewhat technical notice requirements). Third, although not all shareholders need to participate, a quorum - usually defined in the bylaws as a majority of the shares permitted to vote (in no case can it be less than one-third of the shares permitted to vote under Delaware law) - is necessary for any meeting action to have force. Fourth, and most importantly, IF there is unanimous consent (this should be evidenced by executed document) as to the election of the Directors, there is no need to hold the annual meeting at all (i.e., unanimous consent functions "in lieu of an annual meeting" as the statute says).FN2

As already indicated, any other proper business may be transacted at the annual meeting.FN3

So why bother? Failure to hold the meeting does not result in dissolution of the corporation or invalidate subsequent corporate action. Instead, if the corporation fails to hold an annual meeting within 30 days after the designated date or if no date has been designated within 13 months of last annual meeting (or date of incorporation) any stockholder or director may apply to the DE Court of Chancery for an order requiring the meeting to be held.

More generally, however, especially with respect to start-ups and other emerging companies, an annual meeting is 1) evidence that the corporation is not just a shell for the personal interests of a handful of people and 2) a cost-effective guard against future claim(s) that certain corporate decisions did not properly reflect  shareholder interests. It's an easy meeting to transact and document (most start-ups will just need 1)  a waiver of notice and consent signed by all the shareholders and 2) Minutes of the Meeting which identify the directors who have been elected (signed by the "Chair of the Meeting" (an officer or whoever else the bylaws permits to chair the meeting)) and provides some level of protection in the event of a subsequent shareholder suit.

FN1. The location (it can be remote) and time of this annual meeting is built into the bylaws or chosen by the directors if the bylaws are silent (typically, though the timing is linked to either the date of the prior year's annual meeting or the end of the corporation's fiscal year and the applicable state statute will generally set the corporation's principal office as the default meeting location). Note, however, that nearly all statutory allowances given to directors (with respect to choice of location or any matter, really) are qualified (at least under Delaware law) by a generalized rule of equity whereby a court may subsequently find a board action inequitable even if it technically complies with statutory requirements if its implementation compromised a shareholder's ability to participate.

FN2. Caveat to the caveat: In the event that consent from the shareholders is less than unanimous, action by written consent (rather than an actual in person meeting) is still permissible if all of the directorships are vacant and need to be filled by such action.

FN3. Note also that "special" meetings of the stockholders may be called from time to time, customarily by the board of directors but also by any such person as is authorized to call a meeting in the certificate of incorporation or by the bylaws.

Interns, Early Employees and Other Unpaid People

Any business, especially a pre-funded start-up, has an incentive to pay its agents as little as possible. Two issues here.

First, founders rarely think twice about working without pay, the idea being that everyone's compensation is represented by theoretical post-IPO pay out. However, all states, including California, have state minimum wage laws, which means problems might arise if, among other things, someone leaves the company prior to that pay-out (and the issue of his compensation is not contemporaneously resolved and documented).

Second, a start-up might be in a position to hire college students to work their little hearts out for free. This sounds convenient, but, like the decision to roll through a stop sign, requires some caution and forethought.

The legality of unpaid internships is a matter of both federal and state labor laws, which provide narrow exemptions for interns from minimum wage and overtime laws (state laws tend to pretty closely follow the Department of Labor (the "DoL") federal standard). The most recently promulgated federal standard (in the form of an April 2010 fact sheet on maintaining a compliant internship program) sets forth a six factor test for the exemption, which essentially requires:

1. The internship must provide some level of vocational or education-like training (think of an apprenticeship model) similar to the training given in a vocational school or academic institution.
2. The employer cannot derive "immediate advantage” from the intern’s activities. (This has been subject to a few different interpretations and the most reasonable standard of judgment (to the extent regulators' past practice and a 2002 decision by the Department of Labor’s Wage and Hour Division are indicative) seems to be whether the internship is, at the very least, mutually advantageous to both parties.)
3. The intern cannot be doing the same work as a regular employee (the "non-displacement" criterion). He should be doing intern stuff.FN1

As it turns out, this test may be almost impossible to satisfy. The acting director of the federal Labor Department’s Wage and Hour Division has stated, “There aren’t going to be many circumstances [where for-profit companies can have unpaid internships and] still be in compliance with the law.” That's a curiosity because unpaid internship programs are thriving and ubiquitous, at the highest level of business. So, on one hand, internship programs are unethical and illegal, and surely the cause of your ruin, FN 2 and on the other, you're a nit-wit if don't have one.

There are two alternative conclusions in light of this. The standard legal counsel is: pay the minimum wage. Don't roll through that stop sign! It's not invalid advice since a) the fact the DoL promulgated the fact sheet and 6 factor standard has people wondering if the DoL plans to more aggressively regulate; b) it might increase quality of your interns; and c) arguably, any company that can't benefit from a bright eager college kid at a minimum wage salary has problems.

As a matter of practice, however, based on the historical level and type of enforcement by the Department of Labor and their state regulator counterparts (as well as some of their published findings and commentary), the legal exposure from a well managed and properly instituted unpaid internship program is probably limited (depending on the circumstances) so long as you a) document the program and program processes FN3; b) limit interns to part-time work (to respect the DoL's non-displacement criterion) and c) most importantly, employ common sense and a generous spirit, which means the following:

-Hire carefully. FN4
-Be nice to your intern (free lunches, etc.).
-Don't treat him/her like just another employee.
-Don't make him/her hand sponge the bathrooms.
-Accept the fact that by giving your intern(s) meaningful assignments (to respect the DoL's "training" criterion), it's going to require a certain level of management effort, time and hassle.

FN1. The additional requirements include that the internship benefits from the training, you can't promise the intern a job after completion of the internship and he/she must appreciate no wages will be paid to him/her.

FN2. The liability for employers with misclassified unpaid interns includes unpaid wages, overtime and missed meal or rest periods, and certain waiting-time penalties as well as unpaid employment-related taxes owed to governmental agencies.

FN3. First and foremost, you should design and document a rudimentary "curriculum" (put together something) that the company plans to teach the intern. Additionally, you'll need to investigate whether there any state specific requirements (such as ensuring the intern receives academic credit from his school). More generally, you'll need to develop a wariness with respect to any written material (emails/agendas/plans) discussing tasks for which the intern(s) are responsible. Ideally, these materials should include language that reflects the tasks have some educational purpose.

FN4. Probabilistically, the trouble a company encounters in connection with an unpaid internship won't be caused by a random state or federal investigation. It will be caused by a disgruntled intern.

Raising Capital and Securities Laws - An Introduction

A subset of the requirements for seed and VC financing is compliance with federal and state securities laws (the latter tend to track the requirements of the former). As a general matter these laws are designed to protect investors by demanding that sellers of securities (like stock) make proper disclosures to investors (about the value of the business) usually by making information about the company and the sale publicly available. Within the context of start-up financing, however, there are exemptions from these statutory demands (which are very expensive to comply with) so long as the start-up follows certain rules.

The chief exemption at issue here is Regulation D, promulgated under the Securities Act of 1933, which provides, through Rules 504-506 of Reg D, the framework typically used by start-ups when selling stock.FN1 These rules principally turn on the i) amount of capital being raised, ii) type of investor and iii) method of conducting the sale but in specific application can get highly technical (mostly due to "if, then" contingencies between state requirements and federal requirements) so take the summary below as an overview subject to caveat.

As a threshold matter there are capital restrictions. Rule 504 is restricted to "offerings" of up to $1 million, Rule 505 to offerings of up to $5 million and Rule 506 to any higher amount.FN2 Note that it's the "offering" amount, not the "sale" amount, that determines the classification.

Second, there are the investor type and investment method limitations and they operate as follows:

-Rule 504 is the most liberal, placing no restrictions on the number of persons purchasing securities or on what the purchaser may do with the purchased securities (so long in the latter case as the investors are "accredited"). There are no disclosure requirements (with respect to the documents provided to investors) under Rule 504 as long as statements in any "offering materials" (including marketing documents such as a power point or business plan or memorandum) do not violate the Security Act's antifraud prohibitions (by being misleading), HOWEVER, it does not allow (absent state registration of the securities) "general solicitations" or advertisements (there's a slew of technical rules on what constitutes a general solicitation but basically it's marketing to investors with whom there wasn't a pre-existing relationship).

NOTE, however, the state securities laws may qualify Rule 504 (California, for instance, limits (via Section 25102(f)) all such non-registered offerings to no more than 35 "unaccredited" investors).

-Rule 505 like the California rule requires that all but 35 of the investor(s) be "accredited" (i.e., i) a company or investment group with over $5 million in assets, ii) founder(s) of the company, iii) or wealthy people (based on a net worth/income test)).FN3 In addition, to the extent an offering is made to any unaccredited investors (here is the huge difference from Rule 504), disclosure documents must be provided that are generally the same as those used in registered offerings (an exercise costly enough that it effectively bars the inclusion of unaccredited investors). Finally, the securities sold must be "restricted" (i.e., resale in the public marketplace is prohibited absent some Securities Act exemption).

-Rule 506 - the most commonly relied upon exemption for Series A financings - is substantially similar to 505 except i) there is no $ cap, ii) the 35 unaccredited investors (if any) have to be "sophisticated", and iii) it preempts state securities laws, so the only form required to be filed with states (in which there is a sale) is a copy of a "Form D" (filed with the SEC).FN4

The upshot of the above is that companies that sell to friends and family use 504 and everyone else uses 506. In both cases, any information given to investors must be accurate and complete, which means that financial data, if any, should as a mater of best practice be audited and certified and the term sheet and purchase agreement be industry standard.

The final step to close the transaction is to file a Form D SEC notice of sale filing (that notifies the SEC that securities are being sold pursuant to Regulation D and provides basic information on the company and the offering).FN5 In addition, all proper materials must be filed with in each state in which there is sale (i.e, where a buyer is a resident) (in the case of a 506 offering, simply send a copy of the SEC Form D and the applicable state Form D "appendix"). In most states such forms do not need to be filed until the money has been received from the relevant investor(s). The typical grace period for filing these forms is 15 days after the transfer of funds.

FN1. Two caveats here. First, start-ups will also need to seek a separate exemption (Rule 701) for the creation of a stock option pool. Second, other sections of the Securities Act (e.g., Sections 4(2) and 4(6)) also provide exceptions to registration that would be applicable to start-ups raising capital, however, these sections are either less straight-forward (due to judicial interpretation) or niche enough that Rules 504-506 have over time become the "best practices" exemptions applicable to most capital raising scenarios.

FN2. Note that these monetary limitations are calculated on a rolling basis within a 12 month period - the "integration rule." The integration rule is one more incentive to use a Rule 506 exemption (which has no monetary limit).

FN3. Specifically, a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase or ith income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

FN4. 506 but not 504 and 505 preempts state laws because the latter were adopted under Section 3(b) of the Securities Act rather than 4(2).

FN5. None of Rules 504-506 require a filing of a Form D - the benefit of doing so is primarily in that if it's a Rule 506 offering then state securities laws are preempted.

Customer Data and Use/Distribution Disclosure

You care about your customer's privacy but you also want to get rich. This can be a dissonance.

The Federal Trade Commission Act and its state statutory analogues (which govern unfair or deceptive business practices) govern issues related to consumer privacy for commercial web sites (the FTC was given jurisdiction over online privacy and information security in 1999).FN1Federal regulators and state attorneys general are fairly active in investigating companies who misuse customer data. The take-away from such investigations is not that you can't capitalize on the value of such data; however, there are some points to consider:

1 - Doing What You Say. The scrutiny of an online privacy practice begins by identifying how the  web site collects and uses customer data (including non-identifable data such as IP addresses). The reality is that unless the customers/users are uniquely protected (see FN1) there are few business limitations on what you can do with customer data once they knowingly give it to you. The most troublesome (to the company) violations of consumer privacy almost always occur in the following scenario: there is a discrepancy between how customers think a company will use/distribute their data and how that data is actually used and distributed.FN2

2 - (!!!) CONSPICUOUS (!!!) Display. The privacy policy, however finely articulated, can't be buried deep within the site. Best practice (as well as California statutory requirement) is to link to it from the home page.FN3

3 - What You Say. The privacy policy should identify a) what customer data is being collected (this includes ostensibly transactional data like IP address, user names, passwords, etc.), b) how it's being collected, c) how it's being used and why (for security purposes, diagnostics, improving the user experience, etc.), and d) whether it's being distributed to any third parties. Occasionally, you hear an argument that disclosure should be vague so as to avoid accusations of deception later, but that's 1) a bit nefarious and 2) you probably won't get away with it.

With respect to distribution, identify the third parties that will be given the data, and how those third parties will use it. Additionally, even if the data is not being distributed as part of business relationship, disclose that the data may be subject to (i) disclosure via a subpoena or some other governmental request (given enough process the government will always, always, be able to obtain the data (don't act like you're not impressed)) and (ii) an unlawful security breach.

4 - Retention. The policy should also address the issue of how long the company intends to retain the data, which should probably include whether the customer's data may be sold in event of a merger or bankruptcy (and thereby subject to the privacy practices of the acquiring third party).

5 - Appropriate Security Procedures. This is as much a business and technical issue as a legal issue but the history of FTC actions suggests that even well intentioned web sites may run afoul of FTC regulations if their security practices are not reasonable and appropriate to the nature of the data.

6 - Consumer Choice and Changes. Provide methods for users to correct inaccuracies or otherwise review and change personally identifiable information and describe how changes to the privacy policy will be communicated (California statutory requirements).

FN1. Until recently, no law made it a generalized requirement that a web sites have a privacy policy - it was primarily used as a business strategy (to appear trustworthy). The California Online Privacy Protection Act (enacted 2004), because it mandates privacy policies to any California consumer, changed that. In addition, if a web site operates in a) the financial services industry, b) the health care industry or c) can anticipate users under the age of 13, special and additional compliance measures must be heeded. The specific governing laws here are beyond the scope of this post but in brief they include the following: a) Gramm Bliley Leach Act (which requires that special disclosure and opt out provisions (in certain cases) be provided where the web site is collecting financial information), b) Child Online Privacy Protection Act - not to be confused with the Child Online Protection Act - (which applies to the online collection of personal information from children under 13), and c) Health Insurance Portability and Accountability Act (which establishes regulations for the use and disclosure of protected health information).

FN2. Recent studies indicate that there is a widespread disconnect between how privacy policies are articulated at the highest level of management and how privacy practices operate on the ground. In addition, from a business perspective, it might make sense to know the privacy policies of your competitors.

FN3. Google, for example, got heat for failing to put a privacy policy disclaimer on their famously sparse home page (they argued that it appeared on search pages and users could use the search box to find it). After some negotiation, they caved and placed it center bottom.

Privacy Laws and the unBank

The obvious trouble with banking rules regarding consumer privacy (governed in relevant (to this posting) part by Title V of the Gramm Bliley Leach Act ("GBL")) is the compliance costs. FN1 Less obvious is the problem of being a bank and not knowing it.FN2

The advent of the Internet is recent enough that the law with respect to online financial services is still a little unsure of itself. This creates opportunity and legal exposure for early movers.

The definition of a bank according to the GBL (in final promulgation) includes any companies that are "significantly engaged" in providing financial products/services (like loans, financial or investment advice, or insurance). FN3 Thus, certain companies not traditionally thought of as "banks," like certain institutions of higher learning (if they offer loans and at least with respect to "security" of consumer data FN4), auto dealers (if they finance), tax preparers, providers of real estate settlement services, and debt collectors are deemed banks for the purposes of the rule.

Further, because the "significant engagement" definition requires a fact-based determination in an rapidly evolving industry, there remains uncertainty regarding the level of financial activity that is required for a company to become subject to GLB. Do, for example, certain payment service providers (e.g., Paypal FN5) qualify (probably - although it may turn on whether the PSP "holds" onto funds)? Peer-to-peer lending companies (such as Prosper, Lending Club, and Zopa) (quite likely)? Gift card applications (like the mobile ones offered by Starbucks or Target)? Mobile ticketing platforms (e.g., BART)? Nonprofits issuing charitable gift annuities? Providing long-term payment plans subject to interest (for any product)?

A useful short-hand (and oblique low-brow cultural reference) is this: if you're in the business of linking a customer to a bank account, you might be a financial institution.FN6

FN1. The business of providing banking services (online or otherwise) demands careful observance of federal and state rules with respect to the protection of consumer's non-public financial information. The rules are niche and multitudinous (turning in part on whether the bank has an on-going (like a personal loan service) or one-off transactional (like with a check cashing service)) relationship with the customer (only the former are entitled to receive a financial institution's privacy notice automatically; the latter must receive a privacy notice only if such consumer's information is being shared with non-affiliated third parties (with some exceptions)) but, in brief, they require the following: a) disclosure of information collected and distributed to affiliated and non affiliated third parties, b) opt-out procedures, c) annual notices and d) the implementation of an information security program. You can go here for a more detailed run down on the application of these requirements.

FN2. Among the penalties for non-compliance with GLB is up to five years in prison.

FN3. Definition at 16 CFR 313.3(k)(1).

FN4. The GLB governs acts beyond the disclosure of privacy practices, including the requirements for safeguarding the security of private data and the prevention of scams to get customer data ("pretexting").

FN5. Many commentators have found it noteworthy that Paypal distributed an annual, GLB-compliant, privacy disclosure to its users.

FN6. We can probably go further and say that if you receive or transmit bank account information from your customers (even if you don't hold any of the customer's funds, even for a moment) you should seriously consider whether your subject to the GLB.

The Convertible Debt Seed Financing

The trend in seed series financing is to use convertible debt rather than preferred stock. Well reasoned articles on point are here and here but below find a summary of the issue.

The explanation begins with distinguishing the fundamentals of the two forms of financing. Convertible debt works as follows: it starts as just a loan - a right for the lender (in this case an angel investor) to get his money back plus some interest - but changes (or "converts") into a right for the lender to receive stock (of the equivalent value to the loan) at the occurrence of some future event (usually, the next round of financing). Preferred stock on the other hand is just stock, albeit with special economically advantageous liquidation and preference rights as well as certain control rights and that is usually convertible into common stock ("stock" stock, like the kind you buy on eTrade).

If all things are equal, convertible debt militates to the company's advantage, and in a big way. If a company is roughly worth $100K, for example, and Joe Angel gives $50K in exchange for $50K of convertible debt rights, and a year later Sequoia Capital gives $10 Million of Series A at a $20 Million valuation, then Joe Angel's debt converts to $50K of stock, or less than 1% of the company. By contrast, if Joe Angel had received preferred stock, he'd own 50% of a $10MM company prior to the investment.FN1

To correct for this outcome, however, investors now typically require a "cap" or control on the conversion ratio. Other blogs have detailed precisely how this works (the usual mechanic is that the investor gets the better of i) a capped valuation (no matter how high the future Series A valuation is the conversion calculus will hypothesize the valuation to be some predetermined lower amount and ii) some additional multiple (like 2x) of their investment) (both give the investor a higher percentage equity ownership) but the upshot is that the conversion calculus is usually rigged such that ownership levels approximate a preferred stock seed financing.FN2

And yet, convertible debt remains the better option for companies, for two reasons. First, transacting/paperworking a convertible debt is at present simpler (no voting rights agreement, no investor rights agreement, etc.) and therefore cheaper (the usual numbers kicked around are $5-10K versus $25-30K but as model seed series docs become increasingly available this discrepancy will probably diminish) and second, there's no need to perform/argue about an initial valuation of the company.

FN1. What happens if the Series A financing never happens? Usually, a company with no money and no prospects owes the angel investor $50K plus interest. People will move on. 

FN2. One commentator asserts that convertible debt with a cap IS a "priced equity round" or preferred stock financing (due to the way the accounting ends up delivering to the investor the (roughly) same ownership percentage).

The Licensing Contract: Terms to Care About

Most licensing contracts by virtue of their very commercial commonness aren't very treacherous. FN1 They tend to be boiler plate from the licensor (which means being balanced in favor of the licensor but not over so, not enough to undermine the licensee) and, so long as the IP being provided is not "out of the box", receptive to adjustments here and there. FN2

Still, read the thing. Ask the licensor to call out any special provisions they think merit your attention. And then independent of what the other party says give the following four key terms special consideration: a) the scope of the license, b) the term of the license and termination contingencies, c) service level requirements, and d) price protection.

A) The scope of the license. From a business standpoint, this is what matters. This is where the beef is. The scope is typically defined by two variables: the nature of the software being provided (be prepared to find the details describing such in an exhibit to the agreement) and what the licensee is allowed to do with it (in terms of use, modification, distribution, etc.). 

The usual arrangement is that the licensee will receive a non-exclusive (exclusivity is quite uncommon in computer and electronics but less so in other industries), perpetual (for the term of the agreement) license to use (and sometimes distribute) the software in a particular way. (The right to modify or create "derivative works" is more rare and usually will be limited to internal uses or development projects with the requirement any improvements be disclosed and licensed back to the licensor).

The most commonly neglected matter here regards the involvement of third parties such as sublicensees. Make sure it's clear (and often it's not in the boilerplate agreement) what rights you have as licensee to involve a) subcontractors or consultants and/or b) customers and what kind of disclosures and use rights can be given to such persons.

B) Term and termination contingencies. Termination is probably the second most important aspect of a license agreement but weirdly it is commonly overlooked. It almost always makes sense to include a provision in the licensing agreement that allows you to back out of the agreement for convenience before the conclusion of the term. Standard language in software licensing contracts often enables the licensor to be released from the agreement for no cause but provides no such option for the customer (or licensee).FN3 More generally, the agreement should thoroughly detail the precise circumstances under which the agreement may be terminated, the consequences of termination, the obligations of the parties post termination and any available remedies and liabilities.

C) Service levels. Because parties at the negotiation stage tend to focus on the value proposition being provided by the licensor, and not foreseeable defects or system failures, it's easy to overlook service level requirements. A competently drafted licensing agreement, however, should describe a defect resolution process, the circumstances under which it is triggered, and any related refunds or credits to be provided. FN4

D) Price protection. Many licensing arrangements work on monthly or quarterly use fee, predicated on a certain base number of users (usually customers) and then additional fees (sometimes called royalties) per person for all users above that base. This potentially could become quite expensive if the anticipated number of users/customers exceeds expectations so it usually makes sense to create a price cap, allowing for royalties but not to exceed a pre-determined cost for any one month or quarter.

FN1. Three notes here. First, if a business is at the stage where is mostly or fully vertical integrated (quite rare), it would be unlikely to realize a greater profit from licensing than performing the activity itself. Second, by way of background, note that licenses are usually categorized by the licensed subject matter (software, processes, manufacturing know-how, etc.) rather than the legal category (patent, copyrights, trade secrets). The distinction does not really matter but the subtext of this is that your software agreement will likely incorporate various overlapping legal categories (patent AND copyright, for example). Third, this post is written with licensees in mind but may be useful to licensors as well. However, if a start-up is in the business of licensing the stakes are obviously quite higher and you'll be depending heavily on your counsel.

FN2. This does not discuss end user, shrink wrap, click through or other "out of the box" type software license agreements. These agreements tend to be less negotiable (but also less onerous to the licensee in the event of product failure) and typically only get problematic or reasons (mostly dealing with use by multiple employees and the complexities related to agency questions and compliance) beyond the scope of this discussion.

FN3. Sample language: "Either party may terminate this Agreement for convenience at any time during its term by providing at least ([x]) days, in the case of a termination by Licensee, or [[y]) days, in the case of a termination by the Licensor, prior written notice.  Either party may also terminate this Agreement if the other Party materially breaches a provision of this Agreement and fails to cure such breach within (x) days following receipt of written notice thereof. In the event of termination for convenience by Licensor prior to the expiration of the term, Licensee shall pay Licensor a prorated amount of the fee due."

FN4. Sample language: "Licensor will use its commercially reasonable best efforts to supply a correction within reasonable amount of time for any material defect or error in the Software Product following receipt of notice thereof from Licensee. For any such defect that, in the reasonable judgment of Licensee, renders the Software Product effectively inoperable for [x] or more hours, Licensee will be entitled to a credit equal to (x%) of the monthly fees payable or paid, not to exceed in any one month a total of [x] credits."