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.
Saturday, January 29, 2011
Friday, January 28, 2011
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.
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.
Thursday, January 20, 2011
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.
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.
Friday, January 14, 2011
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 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.
Thursday, January 13, 2011
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 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).
Wednesday, January 5, 2011
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."
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."
Monday, January 3, 2011
Incentive Equity for LLCs
In most cases if you intend to offer equity to employees then you should probably organize or reorganize your company as a corporation. It makes things simpler in terms of documentation, internal tracking and HR management. However, if you have a good accountant (see final paragraph of this post) and a good reason to operate as an LLC (see post here), offering employees equity in the LLC is a totally viable, possibly advantageous, option.
Like a corporation, LLCs (along with any other entity taxed as a partnership) can grant equity and options to acquire equity, the practical difference (for an equity holder) just being that LLC equity is called "membership interests" (or sometimes "units" but there's no legal distinction) and corporate equity is called "stock." FN1
As a matter of law, however, membership interests do not fit within the portion of the IRS tax code that applies to employee incentive stock options. From a implementation standpoint this means LLCs cannot simply have their lawyer draw up a standard Stock Option Plan and concommitant Stock Option Agreement (to be signed by each participating employee), make the necessary accounting adjustments (a certain portion of company stock - the stock option pool - will have to be reserved) and call it a day.
Instead, the LLC has to set up a mechanism (usually in the Operating Agreement) to grant employees "membership interests". The implementation of this may be a little tricky but it's not conceptually complicated. The upshot is that somewhere in the LLC Operating Agreement terms and provisions will have to be inserted that a) distinguishes between the "members" (i.e., partners/founders) and the "employees" and the kind of membership interests being received by each, b) describes any applicable vesting requirements and c) identifies (usually as an exhibit) the employees receiving the equity and how much and the vesting schedule (if any). FN2
As a threshold matter, however, an LLC has to choose what KIND of membership interest to grant, and this is where the complexities start.
In essence, while a corporation typically grants employees common stock options, an LLC has a choice to grant employees "capital" interests or "profits" interests. The capital interest is effectively like common stock - it carries the right to a proportionate share (whenever distributed) of the a) existing capital base, b) future profits and c) future appreciation of the company. The profits interest, on the other hand, is only 2/3 of this. It incorporates future profits and appreciation but not existing capital value (which makes it a bit like a stock appreciation right, which is also similar in that (unlike a stock option) it doesn't have a strike price and the employee would at time of distribution just receive the amount of the appreciated value without having to pay anthing). Thus, the profits interest starts out with zero dollar value (since it doesn't share in the capital base of the company) and grows in value as the LLC grows in value.
An example: imagine an LLC grants a new employee a 5 percent profits interest and that the LLC is valued at $10 million. If the LLC later sold for $14 million, the new employee would be entitled to $200 grand, which represents 5% of the $4 million appreciation. The remaining partners would be entitled to 100 percent of the $10 million and 95% of the $4 million appreciation.
The big benefit of a profits interest (and why it exists) is that under current tax law the grant of it does not impose any taxes on the recipient at the time of the grant. FN3 It's not taxable because, as noted, it does not grant the employee a share of the capital base; all the value is forward-looking, thus at the time of grant there is no value being transferred. With a grant of capital interest, by contrast, the employee will have to pay (in the year of the grant) tax on the difference between the value of the capital interest being received and the amount of money that the employee contributes (if any), which partially undermines the value proposition to the employee (or, depending on the value of the LLC, might be flat out cost prohibitive to the employee). FN4
Three administrative issues also merit mention: First, LLCs face a special problem that corporations don't in so far as under tax law a member of an LLC will not be treated as an employee of that LLC by the IRS. He'll be treated as a partner. This means any wages paid to the employee by the LLC won't be subject to taxes by way of a W-2. FN5 Instead, the employee, if paid any wages, would be subject to self-employment taxes (at a rate of 15.3 percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case).
Second, employees should file what is called a 83(b) election when being granted any membership interest. The 83(b) election ensures that the employee will be taxed only at the time of grant (for the excess between price paid (if any) and value receive in the case of the capital interest and for nothing in the case of the profits interest) and not taxed incrementally over time as the value of the interest goes up or, if any vesting requirements are put on the interest (as usually in the case) the vested portion of the interest.
Third, and most importantly, when an employee is granted a membership interest or leaves the company prior to full vesting, your accountant is required by tax law to "book up" or "book down" the capital accounts of the members. Generally, each member's capital account is adjusted to reflect the member's share of any gain or loss that would be triggered if the LLC had sold all of its assets at the time of the adjustment. This activity can be difficult and expensive (basically because book-ups must be based on a fair market value of the LLC's assets and require special tax allocations afterwards). Accordingly, any compensation program that requires multiple book-ups (employees are coming and going with regularity) might not be practical.
FN1
Because the majority of the strategic issues around equity incentives relate to tax law and LLCs are partnerships according to the IRS, most of this discussion also applies to limited liability partnerships.
FN2
If the employees are receiving "profits" interest, it will also probably require a separate profits interest grant agreement (pursuant to the LLC agreement) with that employee.
FN3
The specific "safe harbor" rules here are that there is a tax exemption so long as (1) the interest represents an interest in profits and value accretion (not current capital), (2) the interest is being received for the provision of services, (3) no transfer is made within 2 years of receipt, (4) the interest is not related to a substantially certain stream of income of partnership assets (such as income from debt securities), (5) the partnership is not publicly traded. Revenue Procedure 93-27.
FN4
Note that in very newly formed companies this difference tends to be very small (since the capital of the company will likely be valued at a very low price) and thus not a concern.
FN5
There are creative ways to handle this. A company, for example, could have an operating arm that is a corporation and that pays the employees and a holding arm (which is the LLC). The employees could be given membership interests in the LLC and receive a salary from the corporate entity.
Like a corporation, LLCs (along with any other entity taxed as a partnership) can grant equity and options to acquire equity, the practical difference (for an equity holder) just being that LLC equity is called "membership interests" (or sometimes "units" but there's no legal distinction) and corporate equity is called "stock." FN1
As a matter of law, however, membership interests do not fit within the portion of the IRS tax code that applies to employee incentive stock options. From a implementation standpoint this means LLCs cannot simply have their lawyer draw up a standard Stock Option Plan and concommitant Stock Option Agreement (to be signed by each participating employee), make the necessary accounting adjustments (a certain portion of company stock - the stock option pool - will have to be reserved) and call it a day.
Instead, the LLC has to set up a mechanism (usually in the Operating Agreement) to grant employees "membership interests". The implementation of this may be a little tricky but it's not conceptually complicated. The upshot is that somewhere in the LLC Operating Agreement terms and provisions will have to be inserted that a) distinguishes between the "members" (i.e., partners/founders) and the "employees" and the kind of membership interests being received by each, b) describes any applicable vesting requirements and c) identifies (usually as an exhibit) the employees receiving the equity and how much and the vesting schedule (if any). FN2
As a threshold matter, however, an LLC has to choose what KIND of membership interest to grant, and this is where the complexities start.
In essence, while a corporation typically grants employees common stock options, an LLC has a choice to grant employees "capital" interests or "profits" interests. The capital interest is effectively like common stock - it carries the right to a proportionate share (whenever distributed) of the a) existing capital base, b) future profits and c) future appreciation of the company. The profits interest, on the other hand, is only 2/3 of this. It incorporates future profits and appreciation but not existing capital value (which makes it a bit like a stock appreciation right, which is also similar in that (unlike a stock option) it doesn't have a strike price and the employee would at time of distribution just receive the amount of the appreciated value without having to pay anthing). Thus, the profits interest starts out with zero dollar value (since it doesn't share in the capital base of the company) and grows in value as the LLC grows in value.
An example: imagine an LLC grants a new employee a 5 percent profits interest and that the LLC is valued at $10 million. If the LLC later sold for $14 million, the new employee would be entitled to $200 grand, which represents 5% of the $4 million appreciation. The remaining partners would be entitled to 100 percent of the $10 million and 95% of the $4 million appreciation.
The big benefit of a profits interest (and why it exists) is that under current tax law the grant of it does not impose any taxes on the recipient at the time of the grant. FN3 It's not taxable because, as noted, it does not grant the employee a share of the capital base; all the value is forward-looking, thus at the time of grant there is no value being transferred. With a grant of capital interest, by contrast, the employee will have to pay (in the year of the grant) tax on the difference between the value of the capital interest being received and the amount of money that the employee contributes (if any), which partially undermines the value proposition to the employee (or, depending on the value of the LLC, might be flat out cost prohibitive to the employee). FN4
Three administrative issues also merit mention: First, LLCs face a special problem that corporations don't in so far as under tax law a member of an LLC will not be treated as an employee of that LLC by the IRS. He'll be treated as a partner. This means any wages paid to the employee by the LLC won't be subject to taxes by way of a W-2. FN5 Instead, the employee, if paid any wages, would be subject to self-employment taxes (at a rate of 15.3 percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case).
Second, employees should file what is called a 83(b) election when being granted any membership interest. The 83(b) election ensures that the employee will be taxed only at the time of grant (for the excess between price paid (if any) and value receive in the case of the capital interest and for nothing in the case of the profits interest) and not taxed incrementally over time as the value of the interest goes up or, if any vesting requirements are put on the interest (as usually in the case) the vested portion of the interest.
Third, and most importantly, when an employee is granted a membership interest or leaves the company prior to full vesting, your accountant is required by tax law to "book up" or "book down" the capital accounts of the members. Generally, each member's capital account is adjusted to reflect the member's share of any gain or loss that would be triggered if the LLC had sold all of its assets at the time of the adjustment. This activity can be difficult and expensive (basically because book-ups must be based on a fair market value of the LLC's assets and require special tax allocations afterwards). Accordingly, any compensation program that requires multiple book-ups (employees are coming and going with regularity) might not be practical.
FN1
Because the majority of the strategic issues around equity incentives relate to tax law and LLCs are partnerships according to the IRS, most of this discussion also applies to limited liability partnerships.
FN2
If the employees are receiving "profits" interest, it will also probably require a separate profits interest grant agreement (pursuant to the LLC agreement) with that employee.
FN3
The specific "safe harbor" rules here are that there is a tax exemption so long as (1) the interest represents an interest in profits and value accretion (not current capital), (2) the interest is being received for the provision of services, (3) no transfer is made within 2 years of receipt, (4) the interest is not related to a substantially certain stream of income of partnership assets (such as income from debt securities), (5) the partnership is not publicly traded. Revenue Procedure 93-27.
FN4
Note that in very newly formed companies this difference tends to be very small (since the capital of the company will likely be valued at a very low price) and thus not a concern.
FN5
There are creative ways to handle this. A company, for example, could have an operating arm that is a corporation and that pays the employees and a holding arm (which is the LLC). The employees could be given membership interests in the LLC and receive a salary from the corporate entity.
Subscribe to:
Posts (Atom)