SAFDIE PLLC

Best Employment Benefit: Free Firewood!

Fri, 24 Aug 2012 17:20:18 -0400

From the Warren Wilson College Employment Manual:

When available, full-time employees will be eligible to receive up to one-half cord of firewood each year for use in their own homes. The Forestry Crew, as convenient to their other duties, will produce firewood as a normal product of forest management and clean up on campus. Long-term objectives of College Forest management will not be sacrificed for the production of firewood. Useable waste wood produced on other college lands may also go into the community firewood supply, for distribution by the Forestry Crew.

Each fall the Forestry Crew will announce a firewood pickup day three weeks in advance by campus mail to full-time employees. Those replying by the deadline on the form will be able to pick up their firewood allotment on the designated day. Those residing on campus will have the option of having their firewood delivered to their homes if they choose.

Crowdfunding: Is It Really Worth It?

Wed, 16 May 2012 10:12:00 -0400

CDs Saved: Sonic Youth Two-Pack! A Thousand Leaves and Murray Street

CD Recipient: Kyle Anderson

The recent passage of crowdfunding provisions in the JOBS Act has been hailed in the press as a game changer for startups seeking to raise funds. These provisions are not yet effective as the SEC has yet to promulgate definitive rules related to the legislations. But even a quick look at the Act itself shows that crowdfunding’s potential benefits are accompanied with a heavy burden.

Startups generally raise money through what’s known as a Rule 506 Regulation D offering. Under US securities laws, companies are required to register an offering of securities, an expensive and lengthy process. Rule 506 of Regulation D exempts companies from the registration requirements if they offer securities in a private offering exclusively to “accredited investors,” that is, investors of a high net worth.

There is relatively little paperwork in a Rule 506 offering. The securities purchase agreement will be signed and a Form D will be filed with the SEC. The downside is that the offering cannot be a “general solicitation”: startup founders would need to know a sufficient number of “accredited investors.”

Crowdfunding seeks to remedy these hardships. Startups using the crowdfunding exemption from registration are permitted to offer securities to non-accredited investors. These offerings can be made public using an online “intermediary.” (Those interested in setting up an intermediary can read the SEC’s recent FAQ on the subject.)

On the downside, crowdfunded offerings impose requirements on startups not present in the typical Reg D offering. The press widely reported about the monetary limitations of the amounts raised in crowdfunded offerings and limitations on the amounts invested by individual investors in such offerings. Rule 506 Regulation D offerings have no such limitations. (For the rest of this post, “Regulation D” will be shorthand for “Rule 506 Regulation D offering.”)

Perhaps more onerous are the lesser known burdens described below:

Disclosure documents:

Crowdfunding. An issuer of a crowdfunded offering is required to provide to the investors with certain disclosures, describing risks relating to minority ownership in the issuer, additional share issuances, a sale of the issuer and transactions with related parties. The SEC generally requires issuers to provide risk factors tailored to the specific offering and issuer. While this better protects investors, it means added legal costs to an issuer.
Regulation D. None required. There are benefits to preparing a disclosure document, but in the tech startup world, none is usually prepared.

Fraud reduction measures:

Crowdfunding. Issuers are required to take measures to reduce the risk of fraud, including background and securities enforcement regulatory checks on its officers, directors and 20% shareholders.
Regulation D. None required.

Pre-Offering Filings:

Crowdfunding. No later than 21 days before the first day on which the securities are sold to any investor, the issuer must make available to the SEC and to potential investors any information to be provided by the issuer.
Regulation D. None required.

Non-Financial Disclosures:

Crowdfunding. Issuers must provide investors: (a) its name, legal status, physical addres and website address; (b) names of its directors, officers and 20% shareholders; (c) a description of its business and anticipated business plan; and (d) a description of the ownership and capital structure of the issuer.
Regulation D. None required.

Financial Disclosures:

Crowdfunding. Issuers must provide, among other things: (a) a description of its financial condition and intended use of proceeds; (b) the target offering amount, the deadline to reach the target and regular updates regarding progress; and (c) how the offered securities are being valued, and examples of methods for how the issuer may value its securities in the future.
Regulation D. None required.

Financial Documentation:

Crowdfunding. For offerings that, together with all other crowdfunding offerings by the issuer in the past 12 months, have, in the aggregate, target offering amount of: (i) $100,000 or less, the issuer must provide tax returns for its most recently completed year and financial statements certified by the principal executive officer; (ii) more than $100,000 but less than $500,000, the issuer must provide financial statements reviewed by a public accountant that is independent of the issuer; and (iii) more than $500,000, the issuer must provide audited financial statements.
Regulation D. None required.

Post-Closing Financial Disclosures:

Crowdfunding. At least once a year, crowdfunding issuers must file with the SEC and provide to investors its financial statements and reports of its results of operations, as per rules to be adopted by the SEC.
Regulation D. None required.

Opportunity to rescind:

Crowdfunding. Before each sale, each investor in a crowdfunded offering must be provided in writing the final price and all required disclosure, with a reasonable opportunity to rescind its purchase commitment.
Regulation D. None required.

…And these are only some the requirements set forth in the Act itself: the SEC rules which will be released in a few months will likely contain more hoops to jump through.

Such obligations may very well be necessary to protect mom and pop investors. But it is clear that despite the promise of greater availability of capital, startups contemplating crowdfunding need to seriously assess whether it is worth the monetary and administrative costs.

Bonus fact!: CROWDFUND is an acronym for “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.”

CD’s Saved: Sonic Youth Two-Pack! I got into Sonic Youth a few years too late, after I got into a conversation with Thurston Moore at a Beck show (celeb name drops!). As with all SY releases, the songs on these albums alternate between mellifluous melody and stabbing, cacophonous feedback. Standout Karen tracks: “Karen Koltrane” and “Karen Revisited”

Congrats Kyle Anderson! Sweet two-pack tune-age heading your way!

[After recently marrying and moving into a tiny apt with the wife, I’ve been tasked with reducing my personal possessions. Rather than relegate my carefully curated CD collection to neglect on the shelves of a thrift shop, I’ve decided to give it away, one by one. Listen with care.]

Review of The Entrepreneur's Guide to Business Law

Thu, 10 May 2012 10:08:11 -0400

CDs Saved: Pixeltan, Pixeltan EP; Squarepusher, My Red Hot Car EP.

CD Recipients: Constance E. Bagley & Crag E. Dauchy

Entrepreneurs seeking legal advice on startup issues tend to gravitate to a number of truly excellent VC blogs. But as high quality as these sources are, with only slight exception they exclusively deal with topics related to financings—an out of the ordinary transaction in a company’s life.

For founders looking for smart legal advice on day-to-day legal issues, there is Constance E. Bagley and Craig E. Dauchy’s The Entrepreneur’s Guide to Business Law (2012). The authors, a professor at the Yale School of Management and a partner at Cooley LLP, bring an imposing pedigree to the entreprise.

Starting with helpful pointers for founders seeking to leave their jobs, the book ends with basic overviews on the m&a and IPO process. In between is the meat and potatoes: employment law, intellectual property, operational liabilities and contract law, among others. The e-commerce chapter deals with legal issues rarely dealt with by founders until it is too late.

Real world anecdotes illustrate the challenges and successes of businesses tackling the issues discussed. The comprehensive charts are also extremely useful.

The presentation is soberly even-handed, though a slight large firm bias can be detected in the presentation about selecting legal counsel. New York startups should take note of a bit of a California-centricity in the state law discussions. Also, despite the 2012 printing, because of recently enacted federal legislation, the book will be slightly outdated on securities issues.

But in the end, The Entrepreneur’s Guide to Business Law makes for a comprehensive, trustworthy and easy-to-read reference book. It does not seek to make lawyers out of founders, as much as educate founders on when to call one. Put it on your shelf!

CDs Saved: Pixeltan, Pixeltan EP; Squarepusher, My Red Hot Car EP. Two electro EPs from early millennium. The Pixeltan release harks back to the pre-DFA NY dance punk scene. Less punk and more dance is Squarepusher’s seminal single “My Red Hot Car.” Suddenly beats were on everyone’s top 10 list in 2002!

Congrats Constance & Craig! Sweet, electro tune-age heading your way!

New York Benefit Corporations

Wed, 18 Apr 2012 17:56:41 -0400

CD’s Saved: Spiritualized Four-Pack! Ladies and Gentlemen, We Are Floating In Space, Lazer Guided Melodies, Let It Come Down, and Amazing Grace

CD Recipient: Eric Tarn

In February 2012, New York became the latest in a small number of states to authorize the formation of “benefit corporations.” A benefit corporation is a corporation which generally creates “a material positive impact on society and the environment.”

To qualify as a benefit corporation, its general or specific public benefit must be stated in its certificate of incorporation and the entity must annually evaluate its activities against an independent and transparent third party standard (a cottage industry has sprung up wrt to these).

In addition, the b-corp must deliver a benefits report to its shareholders on an annual basis containing a narrative description of:

the process and rationale for selecting the third party standard;
the ways in which the benefit corporation pursued the general public benefit during the year and the extent to which general public benefit was created;
the ways in which the benefit corporation pursued any specific public benefit included in its certificate of incorporation and the extent to which that specific public benefit was created;
any circumstances that hindered the creation of its general or specific public benefit;
an assessment of its performance relative to its public benefit assessed against the third party standard;
report the compensation of directors; and
disclose the beneficial owners of 5% or more of its shares.

An obvious question might be why is a b-corp necessary? Can’t a company do what it wants with its money without going through the hassle of an annual report, &c.? A corporation’s directors and officers owe certain fiduciary duties to its shareholders. Typically, they are required to maximize shareholder value. In the event officers and directors use corporate resources to act charitably, they are exposing themselves to a shareholder suit. Benefits corporations better insulate these corporate managers from such challenges.

Closely held corporations typically won’t have the same concerns, but may be willing to form benefits corporations for marketing purposes. To be clear, there is no direct economic benefit to forming a benefits corporation, as there is with a nonprofit.

For a full copy of NY’s benefit corporations statute, see Section 17 of the NYS Business Corporations Law.

CD’s Saved: Spiritualized Four-Pack! Spiritualized is at once lushly fastidious in their orchestral tracks and sloppily blistery in their American rock. At either end, it’s an experience like taking drugs to make music to take drugs to. I caught the band at Riverside Church a month after 9/11/01—the perfect comfort food. Spiritualized play Terminal 5 on May 7th!

Congrats Eric Tarn! Four-pack tune-age heading your way!

Support Form D Opacity!

Fri, 16 Mar 2012 11:33:02 -0400

CD Saved: The Barmitzvah Brothers, The Night of the Party

CD Recipient: Fred Wilson, Principal at Union Square Ventures

A privately-held business is under no obligation to publicize its financial results. It has no requirement to disclose the closing of a material transaction. On the contrary, it is often strategically important to keep this information under wraps.

Why then are privately-held startups required to publicly disclose when they raise money from investors in a completely private offering?

A startup’s typical vc or angel round offering entails filing with the SEC a Form D. In the Form D, an issuer reports general information about the investment round, including the amount of cash raised. Filed Form D’s are available for viewing on the SEC’s website. Third party aggregators, like FormDs, make the process of Form D discovery even easier.

For those running a startup, the adverse consequences of announcing these details are clear. As young companies, startups must use every negotiating chip to their advantage. But it is much more difficult for a startup to negotiate the best deals when its counter-parties are aware that it is flush with cash. Also, as noted by Fred Wilson, among others, Form D public disclosure introduces timing complexities into messaging of what is typically a significant corporate event.

To deal with these consequence, some startups seriously weigh noncompliance as a realistic option—an alternative with its own drastic effects. Other startups may deliberately use a vague corporate name in an effort to skirt public notice. But why should this be necessary?

The sole stated purpose of the Form D is to help the SEC and state regulators collect data about private offerings [see beginning section of SEC Release 33-8891]. But if that’s the rationale, there is no reason the Form D needs to be public; it ought to be made confidentially to the SEC and state regulators.

Beyond general prurience, there is simply little compelling justification for requiring a private company to publicly announce raising money in a private offering of securities. I’m generally a big fan of transparency, but the cost-benefit analysis favors Form D opacity.

CD Saved: The Barmitzvah Brothers, The Night of the Party. The Night of the Party is the first release of this Canadian band and showcases their self-professed “electronic-polka” phase. Mind the dreamy, laconic delivery of Hebrew. Standout tracks: “Sfog” and ”Pump #4.”

Congrats Fred Wilson, Principal at Union Square Ventures! Sweet indie tuneage is heading your way!

[After recently marrying and moving into a tiny NYC apt with the wife, I’ve been tasked with reducing my personal possessions. Rather than relegate my carefully curated CD collection to neglect on the shelves of a thrift shop or a dumpsterian fate, I’ve decided to give it away, one by one. Listen with care.]

Review of Brad Feld & Jason Mendelson's Venture Deals

Tue, 13 Mar 2012 09:13:00 -0400

CD Saved: The Moles, On the Street/Rare and Weird (2xCD)

CD Recipients: Brad Feld and Jason Mendelson

In 2011, Brad Feld and Jason Mendelson dropped Venture Deals, a primer on tech startup financing. The authors, managing directors the Foundry Group, are well-known in the industry from their posts on Ask the VC, a blog from which the bulk of the book’s text stems.

Venture Deals unpacks the concepts negotiated in the term sheet, the primary document governing the deal terms of a vc financing. Dispensing advice in plain English and with a wry touch, the authors have a gift for breaking down complex concepts in an accessible, friendly manner. Pragmatism rules the presentation; not much is spent rustling in the weeds (other than to diss on attorneys and other like-minded weed rustlers). Explanations come most to life when accompanied by often amusing real world examples.

While the term sheet lies at the heart of the book, the authors helpfully expand their presentation to other topics of interest to an early stage CEO. Chapters on negotiation style and vc fund structure survey two concepts directly impacting the vc/startup negotiation.

Littered throughout the book are comments from Matt Blumberg, CEO of ReturnPath, showing the entrepreneur’s perspective. These comments mostly supplement the authors’ discussion with real world application of the concepts. To the authors’ credit, Blumberg has been granted the freedom to present points of view contrary to the best interests of investors. For instance, the comments about limiting the vc’s co-sale rights or no shop clause (pp. 87 and 92, respectively).

The book does lightly pass over a couple of topics where greater detail could be useful. The use of convertible notes in an early round has only truly taken root over the last few years, but in light of how widespread the practice has become, it is difficult to excuse the omission of a detailed discussion. Also, it would be helpful to include a review of some of the pre-vc-financing legalities of organizing a startup, especially since many of these decisions are dictated entirely by vc concerns. Last, while there are obvious challenges in presenting a clear discussion about capitalization tables and specifically how they change from one financing round to the next, I think the authors are up to the task at giving more detail than the three pages included in the book.

But these shortcomings are easy to forgive; the writing style is just so plainly friendly and wry that I found myself chuckling on more than a few occasions. Not often that that happens when reading informative business books.

CD Saved: The Moles, On the Street/Rare and Weird. Didn’t know that much about The Moles until I heard them on Ken’s show on FMU. They have an innocent, but complex sound. Fun fact: Lead singer Richard Davies is an attorney! Standout Tracks: “Surf’s Up” and “Europe By Car.”

Congrats Brad Feld and Jason Mendelson, Managing Directors of the Foundry Group! Sweet indie tuneage is heading your way!

"Accredited Investor" Definition Guidance

Wed, 29 Feb 2012 19:52:46 -0500

CD Saved: Godspeed You! Black Emperor, Lift Yr Skinny Fists Like Antennas to Heaven

CD Recipient: Mary L. Shapiro, Chairwoman of the Securities and Exchange Commission

Whenever any company offers securities for sale, the offering is required to be registered with the SEC and state authorities, unless an exemption from registration can be found. The typical exemption used by startups is Rule 506 of Regulation D, which permits a company to offer and sell securities without registration with federal or state authorities provided that all the offerees meet the definition of an accredited investor.

In December 2011, the SEC put into effect a modification of the definition of an accredited investor. Yesterday, the SEC published guidance about the calculation.

In order for an individual (as opposed to an entity) to qualify as an “accredited investor,” he or she must:

have had 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; OR
have an individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person.

The SEC’s December modification in December 2011 was to exclude the value of the primary residence. The guidance explains in plain English the calculation with respect to mortgages related to the primary residence.

CD Saved: Godspeed You! Black Emperor, Lift Yr Skinny Fists Like Antennas to Heaven. GY!BE has an epic, biblical sound. Be prepared to be moved. Lift Yr Skinny Fists is from 2000. Outstanding Track: the whole thing.

Congrats Mary L. Shapiro, Chairwoman of the Securities and Exchange Commission! Sweet tuneage heading your way!

For each blog post, I will send a deserving recipient one (1) CD from my collection that I was going to trash since getting married and moving in with the wife.

Delaware Franchise Taxes and Annual Reports Due Today!

Wed, 29 Feb 2012 12:27:00 -0500

CD Saved: The Breeders, Mountain Battles.

CD Recipient: Jeffrey W. Bullock, Secretary of State of Delaware.

For all those Delaware corporations, the state’s franchise tax and annual report are due today. A nifty calculator can be found on the Secretary of State’s website. Startups with loads of authorized stock, but that much in the way of assets will want to review carefully the assumed par value calc. Companies can submit the report and pay online.

For each blog post, I will send a deserving recipient one (1) CD from my collection that I was going to trash since moving in with the wife.

CD Saved: The Breeders, Mountain Battles. I had always liked The Breeders since Cannonball, but when I heard them open for Nirvana, I realized just how good they were. Mountain Battles is their most recent release. Standout track: “We’re Gonna Rise.”

Congrats Jeffrey W. Bullock, Secretary of State of Delaware! Sweet tuneage is heading your way!

CD's for Questions #2: Guide to Bootstrapping Startup Legal Costs

Thu, 23 Feb 2012 18:13:51 -0500

Question: What’s the best way to bootstrap without losing out down the road? Asked by @evilldave

CD Saved: RJD2, “Since We Last Spoke.”

If you’re bootstrapping a tech startup, you want to save money, but not at the cost of making any fatal mistakes that would jeopardize your ability to raise funds and otherwise run a successful business. It’s always best to have an attorney looking over your shoulder, but if you simply don’t have the money to hire an attorney, the incorporation process is relatively straightforward and is ripe for bootstrappery.

Bootstrapping will take longer than if you just hired someone to do it. I’d only advise bootstrapping in the context where you are not rushing. For purposes of this discussion, we’re talking about a tech startup which will be seeking vc financing.

1. Certificate of Incorporation. This document is filed with the secretary of state that forms your entity. You can find text of a certificate of incorporation at Orrick’s website. I annotated another form here. For the relevant terms contained in a certificate of incorporation, see Ryan Roberts’ post. Delaware has a form of certificate of incorporation posted online; don’t use it, but you can use the cover letter. Unless you have a friend who lives in Delaware, you will need to hire a service company to serve as agent for service of process in Delaware. One of the cheaper outfits is Vcorp.

2. Bylaws. In the pre-financing stage, you can put together your own bylaws. A form can be found at Orrick’s site. Again, I’ve annotated another form here.

3. Action of Incorporator. This is the paper trail selecting the initial board of the corporation. A form can be found at Orrick’s site. What’s that? I’ve annotated another form here.

4. Obtain an EIN. Never pay someone to do this for you. Go to the IRS’s site and do it yourself.

There are other basic items a startup needs to do from its inception, such as issue restricted (vesting) stock to the founders, file 83(b) elections, sign intellectual property assignment/confidentiality/employment at will agreements. Orrick’s site has forms for these things; as does Goodwin Procter’s. However, my opinion is to get an attorney for these steps.

RJD2, “Since We Last Spoke.” Discovered RJD2 flipping vinyl at Halcyon, the Brooklyn cafe/record shoppe on Smith Street during the heyday of turntablism. There’s nothing on this CD as magical as “Ghostwriter” from his previous release, but it will still make you want to wear a velvet jumpsuit. Standout track: “1976.”

@evilldave: Sweet tunes are coming your way! Wife Safdie says move to the groove!

For an explanation of the whole “CD’s for Questions,” see here.

CD's for Questions #1: S-Corps vs LLC's

Tue, 21 Feb 2012 17:17:00 -0500

Question: Any reason to incorporate as an S-Corp rather than LLC (in NY)? Other than cost of publication? Tweeted out by: @jasongelman.

CD Saved: Think About Life, “Family.” For the whole “CD’s for Questions” explanation, see here.

[First things first: if a startup will be seeking VC financing, they should know that prior to closing that financing, the startup will have to be a c-corporation. VC’s will not invest in pass-through entities, like LLC’s and s-corps. Delaware law makes it easy from a corporate perspective to convert these NY entities into a Delaware c-corp (the state preferred by VC’s). Plenty of startups initially form their entity as a pass through, take the benefit of the losses on their personal income taxes and then convert prior to a VC financing. However, depending on the business, there may be adverse accounting ramifications to a conversion.]

I generally favor LLC’s because of their flexibility. As products of the 90’s, LLC’s tend to have less corporate formalities than corporations: internal governance and economic understanding among the members tends to be more the result of contract law, set down in the entity’s operating agreement.

As a result of its recent vintage, there are some uncertainties with respect to the LLC form. For instance, how much in the way of fiduciary duties can a NY LLC contract away? These issues are still being litigated; legal blogs are atwitter with recent Delaware case law on this issue.

On NY’s LLC publication requirement, depending on the circumstances, I may advise startups not to comply. More detail can be found here.

S-Corps tend to be more rigid and limiting. For instance, there can be only one class of shares in an s-corp. An investor cannot be issued equity with any economic or control preferences as compared to another shareholder. The number of shareholders in an s-corp is capped at 100. No foreign shareholders are permitted. And only individuals can own shares of an s-corp.

The one advantage I’ve found with an s-corp is a potential savings in the self employment tax. For a good description of how it works, see here. But I know other accountants who are not comfortable with the trick.

Again, I generally favor LLC’s, but I’ve seen other skilled advisors go the s-corp route.

Think About Life, “Family.” I discovered Think About Life on an online blog and since then have caught them live around half a dozen times. Each time is a better dance party than the last. You can cancel your gym membership. “Family” is their sophomore release; this CD is from the Canadian pressing on Alien8 from May 2009. Standout track: “Havin’ My Baby.”

@jasongelman: Sweet tunes are coming to you! Wife Safdie sends her gratitude.

SAVE A CD'S LIFE; GET YOUR LEGAL QUESTION ANSWERED

Tue, 14 Feb 2012 16:52:32 -0500

Background

On December 18, 2011, I married a wonderful woman (hi, Jenna!). Upon returning from our honeymoon, we quickly came to the realization that our marriage would be even better if we could actually fit inside our Upper West Side apartment.

Since then, I’ve reluctantly disposed of beloved, if hole-y, concert t-shirts, my dusty bocce set and a stack of embarrassing CD’s. I’ve successfully managed to withstand attacks to my import CD collection. But it’s inevitable that I surrender to demands of giving away dozens of other awesome CD’s.

So, I’ve decided to give away this collection, one by one: Anyone who tweets me a legal question about startup law will receive an answer and an awesome, free CD.

Oh, I’m a corporate attorney. To prove it, here’s some fine print: One CD per address; first tweet, first serve basis; offer only available in the United States; NY and federal legal issues only; awesomeness of CD not guaranteed.

Offer expires March 15th! Remaining CD’s will be compacted! Or given to the Salvation Army Thrift Shop where they will languish like the Ark of the Covenant at the end of Raiders of the Lost Ark.

Won’t you please save a CD’s life today?

Here’s how it works:

1. Tweet me your startup law question to @abesafdie
2. I will tweet back the answer, simulposted on this tumblog
3. Wait excitedly by the mailbox for a CD selected at random from my collection, along with a handwritten note/illustration. Possibly signed by my wife (hi, Jenna!).

The stats:
51 CD’s
2 cassettes
0 8-tracks

Win, win, win!

Employment Posters!

Thu, 02 Feb 2012 18:39:08 -0500

Full compliance with employment law implicates a delicate venn diagram of federal, state and local rules and regulations. To ensure employees are aware of their rights under these rules, federal and state governments require employers to physically post certain notices in a conspicuous spot in the workplace. For instance, information about minimum wage and overtime policy must be displayed pursuant to NY law; at the same time, a poster regarding the rights of migrant and seasonal agricultural workers may have to be posted according to federal law. How’s a business to know what posters should be decorating its bulletin board?

The federal government has a surprisingly good Q&A to help employers determine which posters to display. NYS employers can consult this chart to suss out the required posters. Employers have the ability to print up the appropriate posters/notices from these websites. Another option is to just buy an all-inclusive (laminated!) federal/state poster from an online purveyor. You just have to be okay with including agricultural worker disclosure on your workplace walls.

The Ticketmaster Monopoly, a Rant + a Call

Fri, 27 Jan 2012 16:59:00 -0500

Another swath of Bruce Springsteen tickets sold on Ticketmaster, another Ticketmaster fail. At 10a this morning, tickets went on sale for five local Bruce shows, as well as the UK band Pulp’s first local show in ten years. The Ticketmaster site was completely down a couple of minutes later. Users timely logging on were met with a webpage informing them to expect a 15 minute wait time and that they ought not refresh or leave the page, lest they lose their spot in line. Based on comments on BrooklynVegan, fans stayed on the page for 90 minutes or more, ultimately leaving the site without the ability to purchase tickets. Others complained of initially obtaining tickets, only for the tickets to be lost during the checkout process. Ticketmaster finally acknowledged an issue two hours later, citing “high volumes of traffice” in a retweet to a frustrated Florence and the Machines fan.

There has to be a better way.

I was one of those fans attempting to purchase Pulp tix at 10a sharp, so this post is most definitely personal. Amid my attempts to buy tickets this morning, it was impossible not to think of the Department of Justice’s approval of the Ticketmaster-LiveNation merger.

In approving the merger, the DOJ was seemingly solely concerned with pricing: would the transaction lead to higher consumer prices? This is the classic analysis of the DOJ in deciding whether to approve an m&a transaction with possible monopoly implications. But this analysis is short-sighted. Price is just one of many factors in evaluating whether a monopoly poses a concern. A more effective approach would take into account all factors of consumer experience.

Certainly, pricing was properly one of the concerns. While the face value of the ticket prices may not have increased since the merger, Ticketmaster still gets away with gouging consumers with irrational ticket fees. Witness the $14 surcharge on a $35 ticket for the Pulp show. A surcharge equal to 40% of the ticket price!! They are the only ticket purveyor with Radio City Music Hall, so there is no alternative a fans can turn to. (There were reports of people waiting in person by the box office only to be turned away.)

But more insidious than fee gouging is that monopoly creates an environment of complete lack of accountability to the consumer, an utter disincentive to spend money on bettering the user experience. There is nowhere else consumers can go. (Similar to customer service at kosher restaurants, but that’s a rant for another day.) The only incentive they have to create a decent customer experience is the concern that regulators will get involved. (Hi, Chuck Schumer!)

Ultimately, persuaded the Live Nation-Ticketmaster merger would not unduly increase ticket prices, the DOJ approved the transaction. But by being overly concerned with post-merger ticket prices, the DOJ missed the opportunity to institute some real change with the relationship btw Ticketmaster and its consumers. The DOJ could have conditioned their approval on Ticketmaster implementing some real change. Here’s what I would like to have seen foisted upon Ticketmaster:

1. Transparency, or the Ticket Countdown Clock. Prior to the beginning of a sale, the Ticketmaster is required to disclose how many tickets are for sale to the public and their location. Even better if fans could see the amount of tickets available as tickets are sold, but, considering the speed of some of the ticket sales, I’m not sure if the technology is yet there. It’s just difficult to forget how LCD Soundsystem’s farewell concert at MSG apparently sold out in under a minute. Adjusting the expectation of the consumer makes for a completely different user experience. Just ask any NYer about the awesomeness of those new Subway Countdown Clocks. I would also like to see public report afterwards as to the speed tickets sold, and through what outlets.

2. Forced Competition. The biggest roadblock to competition is the exclusive deals Ticketmaster has with concert halls, a problem made even more acute after the merger. As part of its approval of another blockbuster deal—the Sirius-XM deal—the DOJ forced the new mega-entity to permit minority and noncommercial programmers use 4% of its satellite channels. That is, the DOJ forced the new entity to allow competitors, albeit small ones, use its resources. In this context, I would have liked to have seen the DOJ mandate that X% of tickets at Ticketmaster’s exclusive concert halls be sold by another ticket purveyor. The logistical cooperation, while a challenge, is one that I think could be overcome with the appropriate technology.

Certainly, Ticketmaster has abused the public prior to its merger with LiveNation. One can only look back wistfully at the opportunity passed up by the DOJ to require real competition and address the consumer’s real concerns. It’s currently too late for the feds to mandate forced competition. But is it too naive to think that consumers could garner enough pressure for Ticketmaster to implement some basic disclosure reform?

Collecting NYS Sales Tax

Thu, 26 Jan 2012 17:39:06 -0500

New York companies selling tangible goods in New York are required to collect NYS and local sales tax. In this post, I provide a general summary of collecting NY sales tax.

1. Twenty days prior to any sale of goods, the NY business must apply for a certificate to collect sales tax. NYS provides for an online application at www.nys-opal.com. Penalties for operating a business without a certificate are $500 for the first day, $200 each subsequent day.

2. Calculate the appropriate sales tax to collect. Different counties (and cities) have different tax rates. A New York company selling merchandise online to NY customers must use the tax rate of the delivery address. Sales tax must also be collected on shipping and handling charges. Note that the tax rates are subject to change. (Online businesses will have to ensure they have a mechanism to charge the correct tax rate at checkout.)

3. Sales tax collecting companies are generally required to submit a sales tax return on a quarterly basis, along with the taxes charged to customers. The “quarterly” basis for this purpose is not the standard calendar quarter. For instance, the next quarter ends on February 28th. The sales tax return is due no later than 20 days after the end of each quarter. If after four quarters, total tax due did not exceed $3,000, the state may reclassify a business as an annual filer. Businesses with total taxable sales in excess of $300,000 in any of the previous four quarters are required to file returns on a monthly basis. Sales tax returns may be filed online.

The above holds true with respect to NY companies. Out-of-state businesses are not generally required to collect sales tax from sales to NY customers. The question of whether or not a business has sufficient contacts with NYS that obligates it to collect sales tax is highly determinative on the specific facts and circumstances. If a company maintains a physical office or presence in NYS, then it is generally required to collect sales tax for such sales. According to NY law, however, even an out of state businesses may be required to pay sales tax on goods delivered to NY customers. For instance, if it regularly delivers sales to NYS residents in its own vehicles. More examples can be found in this Bulletin. With respect to out-of-state online businesses, there are still many open questions, as evidenced by the ongoing Amazon sales tax hoopla.

In general, I’m pleased to recommend this Guide put out by NYS on sales tax collection.

Are there any Securities Law Issues with Gifting Shares?

Fri, 11 Nov 2011 15:28:00 -0500

[Ed. Note: This post was originally written in response to the announcement in TechCrunch about the beta launch of a new organization called 1% of Nothing. The article suggested that the group sought to have startups donate, at their initial startup stage, 1% of equity to the charity of their choice. It seems that the group actually encourages startups to make the pledge at the initial stage, but the donation actually occurs only if and when an exit occurs. With such a plan, no securities laws issues would seem to be implicated. I’ve therefore rewritten this post to apply to a situation where a company seeks to give shares away. The original post can be found here.]

Question: Can a startup company give away small amounts of shares in its company to users in exchange for their promoting or registering at its website?

Answer: Such a share giveaway program would run afoul of US securities laws.

In 1998, Travelzoo, then a relatively unknown website, created a splash when it offered free stock in the company to whoever registered with the site. The SEC never challenged Travelzoo on these issuances, but in subsequent rulings regarding other startups offering free shares to users, the SEC articulated the general rule that such offerings violate securities laws.

The default rule in the United States is that every offer to purchase securities must be registered with the federal government, and usually with the state government, unless an exemption can be found. Registration entails the preparation of a hefty registration statement and a lengthy SEC review. This rule applies to all companies, including small, privately held companies.

There are exemptions from this requirement. One such exemption, upon which startups typically rely in raising funds, is to offer the securities to only to accredited investors and not via a “general solicitation.” A type of offering that would be impractical for Travelzoo and its ilk.

According to the SEC, share giveaway programs violate securities laws because they are sales of securities “for value.” These companies did not receive money for their shares, but, according to the SEC, they did receive “value” in the form of consumer information when they registered with their sites.

If startups received nothing in return, the share giveaway programs should not qualify as a sale for value. However, this is a fact specific determination. According to the SEC, a giveaway program must be registered if the “purpose of the ‘gift’ is to advance the donor’s economic objectives rather than to make a gift for simple reasons of generosity.” [See Section IV of this SEC Administrative Proceeding related to a share giveaway.]

Bottom line: A startup seeking to institute a share giveaway program in order to generate higher user counts or for a marketing ploy would be required to register the offering, unless an exemption can be found.

Legal Issues with Breaches of Customer Data

Fri, 07 Oct 2011 14:54:48 -0400

While it’s de rigeur for a company to collect and store its customers’ personal information, the practice brings with it increased risk of unauthorized release of the data. A customer data breach creates not only a marketing nightmare, but also may cause legal headaches and monetary liability.

Upon a data breach, each state with a data breach statute requires a different notification protocol to follow with respect to the data of its own residents. Each state also has specific carve outs from liability, for instance, if the breach is “immaterial” or if the personal data was kept encrypted. Each state also has different standard of potential liability. (Four states have not adopted such statutes.)

For example, if a company experiences a data breach affecting New York residents, it would be required to disclose the data breach “in the most expedient time possible and without unreasonable delay upon determination of a data breach.” The disclosure notice must be sent to three New York State entities: The Attorney General, the Office of Cyber Security & Critical Infrastructure Coordination and the Consumer Protection Board. Failure to comply with this law could lead to fines from the state. And all this is for just one state.

Considering that any security breach typically means that all customers’ data will be affected, managing the notification regimes of all fifty states in “the most expedient time possible” seems an extremely difficult burden.

This is clearly an issue ripe for federal involvement.

Some interesting resources:

1. New York State Factsheet. Describes the law in simple forms and includes a form notification letter for reporting breach to state agencies. The full text of the NYS statute can be found here.

2. Credant Summary of State Law. Credant is a commercial data breach solution, but their website has a pretty simple drop down menu for each state. It includes a summary of each state statute and a link to each statute. Another helpful summary chart of the statutes can be found here, prepared by Scott & Scott, LLP, a New York based law firm.

3. DataLossDB. DataLossDB reports on incidents of data breaches and, to inform the general public, tweets them out. Also, considering the breach reporting forms are delivered to the states, they can be released under freedom of information act. DataLossDB then will obtain copies of the reports and post them on the website. See, for example, here with respect to data loss occurring as a result of a stolen laptop.

Annnotated Bylaws

Fri, 23 Sep 2011 14:17:00 -0400

Corporate bylaws are the internal governance documents of a company. They’re highly standardized and can drag on for pages—I’ve seen many eyes glaze over at the sight of them. While founders need not commit corporate bylaws to memory, they ought, at least, be familiar with the topics treated in them.

To that end, below find a summary of the typical contents in bylaws, keyed to the usual section headings. I’ve added annotations where appropriate. For those more hardy souls, the full text of bylaws with the annotations can be found here.

There are many free forms of Delaware bylaws available online; for purposes of this exercise, I used the form prepared by Wilson Sonsini for TheFunded (which can be found there in Word). Most free bylaws encountered online are outdated; they contain overly formal procedures. The Wilson Sonsini form does a good job of taking into account new technology (email!) and prevalent practice in the tech startup world.

As a refresher: bylaws are adopted upon formation of the entity. Banks will ask to see the bylaws, along with the certificate of incorporation and EIN, in order to open a bank account. Unlike a company’s certificate of incorporation, bylaws are not typically amended as the company closes rounds of financings. Also unlike the certificate of incorporation, they are not publicly filed.

BYLAWS

ARTICLE I - MEETINGS OF STOCKHOLDERS

1.1 Place of Meetings. Shareholder meetings may take place either in or out of Delaware, or via conference call. [The board has the right to determine the place of shareholders meetings. This right is sometimes used to their advantage by holding hostile meetings in remote places where broad shareholder attendance will be difficult. On behalf of one activist client, I once had the pleasure of traveling to a shareholder meeting in wonderful Marshfield, WI. If you happen to stop by, send regards to the guys at the Blue Heron.]

1.2 Annual Meeting. Annual shareholder meetings are required for the minimal purposes of voting in directors. In certain circumstances, the shareholders may elect directors by acting by “written consent,” which happens when all shareholders sign a document approving the election of named directors. [Note: Informal meetings with shareholders do not generally qualify as “shareholder meetings” for purposes of bylaws. Shareholder meetings are those in which shareholders are asked to perform a corporate action.]

1.3 Special Meeting. Outside of an annual meeting, special shareholder meetings can be called by the board, officers and shareholders owning more than a specified percentage of outstanding shares. [Note: Board will call special meeting if the company seeks to to consummate a transaction for which shareholder consent is needed and it does not want to wait for the next annual meeting. A shareholder might call a special meeting to depose board members. The form bylaws provide that holder(s) of 10% of the shares are entitled to call a special meeting; a somewhat low threshold.]

1.4 Notice of Stockholders’ Meetings. Notice of the shareholders meetings cannot be given too early or too late, but only within 10-60 days prior to the meeting.

1.5 Quorum. In order to take action at the meeting, the presence of a majority shares represented in person or by proxy is needed. If a quorum is not reached, the meeting must be adjourned. [Note: Quorum is typically a majority, but this standard can be modifed.]

1.6 Adjourned Meeting; Notice.

1.7 Conduct of Business. An officer is responsible for the process and conduct at the meeting; another officer for taking minutes.

1.8 Voting. General rule of one vote per share held as of the record date, unless otherwise stated in the certificate of incorporation. [Note: The certificate of incorporation can include enhanced voting rights, for instance to holders of class F common stock.]

1.9 Stockholder Action by Written Consent without a Meeting. [Note: Shareholders need not call a formal meeting if enough consent in writing to perform a corporate action. The general rule in these bylaws for acting by written consent is that a majority of outstanding shares need to consent to corporate action, but unanimity is required for election of directors.]

1.10 Record Date for Stockholder Notice; Voting; Giving Consents. Mechanics of voting at the meeting.

1.11 Proxies. [Note: Sometimes a proxy will be needed just to reach a quorum.]

1.12 List of Stockholders Entitled to Vote. The company must make available to its shareholders the names and addresses of all the shareholders. [Notes: Bylaws need not include this section; it is a shareholder right stated in Delaware law. But it is another provision important for irate shareholders. In order to reach the threshold where a shareholder can effectuate a takeover of a board, the shareholder will most likely have to contact other shareholders of the company and to vote together. This is the mechanism by which shareholders can find out contact information about one another.]

ARTICLE II - DIRECTORS

2.1 Powers. Directors hold the ultimate management authority, subject to shareholder consent required for certain transactions.

2.2 Number of Directors. The Board selects the number of Directors. [Notes: Neither the certificate of incorporation nor bylaws typically sets the number of board members. The number of initial board members will be set by the company’s incorporator. After that point, the board itself will vote to increase or decrease its size.]

2.3 Election, Qualification and Term of Office of Directors.

2.4 Resignation and Vacancies. This section deals with several contingencies of a director being unable to perform his or her duties, such as death, disability, etc. [Notes: A sign of a quality set of bylaws is that it deals with a number of contingencies. Just so non-practitioners are aware: the lawyerly preoccupation with the macabre is not confined to clients. The paranoia extends to the practice of attorneys ensuring a junior associate shadows everything in a deal, partly in case the senior attorney gets hit by a bus.]

2.5 Place of Meetings; Meetings by Telephone. Board meetings may take place either in or out of Delaware, or via conference call.

2.6 Conduct of Business. Provides for a chairperson of the meeting and a secretary to take minutes. [Notes: Taking minutes is no trivial matter, and the person charged with the task does not have some podunk ministerial task. Among the fiduciary duties owed by directors to a company is the duty of care. The duty of care is dispensed when directors properly evaluate and weigh decisions affecting the company. A director can evidence proper care by pointing to the board meeting minutes. On the flip side, too much detail in board meeting minutes may give antagonistic shareholders something to hang their hats on and second guess the board’s decisions or even challenge the board’s proper dispensation of its duties. (Shareholders have the right to review board minutes. Disgruntled shareholders will pore over these minutes carefully for any cause to challenge a board.) Drafting board minutes is very much an art. And of course, regularly maintaining a set of corporate minutes is crucial to fending off claims seeking to reach the assets of the shareholders, or “pierce the corporate veil.”]

2.7 Regular Meetings.

2.8 Special Meetings; Notice.

2.9 Quorum; Voting. Typical rule is one director, one vote, except if the certificate of incorporation provides otherwise. [Notes: The clarifications with respect to greater voting power are important, especially for those companies who have issued class F common stock, which ordinarily entitles its holders to name one director having two board votes.]

2.10 Board Action by Written Consent Without a Meeting.

2.11 Fees and Compensation of Directors. The board can fix their own compensation. [Note: This right, of course, is mediated by the fiduciary duties they owe to the company and the prospect of being voted out.]

2.12 Removal of Directors. Directors can be removed by shareholders owning a majority shares.

ARTICLE III - COMMITTEES

The Board can delegate its authority to committees. These committees have to take minutes and otherwise conform their conduct to board meetings. [Notes: Some might be surprised by the amount of space given to committees and subcommittees. The committees dealt with here are no mere party planning committees, but real committees wielding significant power to make real decisions on behalf of the company. Also, these committees tend to be created at highly sensitive moments. For instance, if a company is seeking to enter into a transaction with a party controlled by a board member—a highly charged situation—independent committees are mechanisms to better insulate a board from successful claims of breach of duty of loyalty.]

ARTICLE IV - OFFICERS

4.1 Officers. Lists the titles of officers. [Notes: While directors govern the overall vision of the company, management of day to day affairs is the domain of officers. The line between those “significant” actions requiring board consent and officers’ daily operational decisions is not always clear. A subject for a separate post. Some bylaws specify the distinct role of each titled officer; many do not. I think the distinction is an unnecessary formality.]

4.2 Appointment of Officers. Officers are appointed by the board and serve at their pleasure.

4.3 Subordinate Officers. With board consent, subordinate officers may be appointed by other officers.

4.4 Removal and Resignation of Officers. Officers may be removed by the Board. [Notes: This provision, of course, is subject to any contractual requirements under an employment or consulting agreements with such officer, if any.]

4.5 Vacancies in Offices.

ARTICLE V - INDEMNIFICATION

The company will indemnify officers and directors for losses related to their serving in their position. [Notes: There are two types of indemnification: losses related to a third party proceeding or those with respect to a shareholder lawsuit on behalf of the company, or a “derivative suit.” These bylaws treat both separately (there are some differences). Also, the mere fact that a company is willing to indemnify a director or officer may not be sufficient to those indemnified individuals. Considering the costs of defending an action, the indemnity has real value only if the company will reimburse the costs in real time. Last, all companies beyond the initial, initial startup phase should seriously consider obtaining D&O insurance. Certainly, if vc’s are serving on the Company’s board, they often require it.]

ARTICLE VI - STOCK

6.1 Stock Certificates; Partly Paid Shares. [Notes: Corporations are not required to issue physical stock certificates. Investors will generally require it, as will banks who seek to own a pledge in the shares of a company. Although they look official, I look forward to someone disrupting the staid design of stock certificates. Two officers will have to sign the certificates, depending on title—one of the few places where an officer’s specific title matters. The issuance of stock needs to be supported by consideration. This can take the form of cash payment, a loan, or labor. Either way, one may not issue stock for no consideration.]

6.2 Special Designation on Certificates. The certificates may include special designations referring to certain rights of holders. [Notes: If the shares are subject to restrictions on transfer, a short notice to a potential transferee will appear on the certificates (in allcaps. so you know it’s important.). This puts a potential purchaser on notice of the restrictions.]

6.3 Lost Certificates. Procedure for shareholder who lose a stock certificate.

6.4 Dividends. [Notes: Companies interested in issuing dividends ought to rope in an experienced corporate attorney before doing so. Delaware companies are only permitted to issue dividends in certain situations. State law concern is that a company needs to be properly capitalized in order to make actual and potential creditors whole. Dividends may be an improper method of defrauding creditors from amounts owed to them at the expense of enriching shareholders.]

6.5 Stock Transfer Agreements. The company can enter into an agreement with certain shareholders to restrict the transfer of their stock.

ARTICLE VII - MANNER OF GIVING NOTICE AND WAIVER

[Certain details about giving notice for shareholder meetings, by email and for shareholders sharing an address.]

ARTICLE VIII - GENERAL MATTERS

8.1 Fiscal Year. The board will affix the end of the fiscal year for accounting purposes. [Note: The board will typically do this in the first board meeting. The fiscal year will usually coincide with the calendar year, but it does not have to.]

8.2 Seal. The company may adopt a corporate seal. [Notes: More evidence of the age of the corporate form. Wax generally not recommended.]

8.3 Annual Report

ARTICLE IX - AMENDMENTS.

The bylaws may be amended by the board or the shareholders. [Notes: The company may grant the power to amend the bylaws to the board, but it cannot take it away from shareholders.]

Confidentiality Agreement Basics: Presentation Notes

Wed, 31 Aug 2011 17:59:00 -0400

I gave a presentation this afternoon on Confidentiality Agreements. Here are my somewhat edited notes.

Every company, no matter the size or industry, will enter into confidentiality agreements with a fair degree of regularity. Many businesses, especially startups, simply lack the money for an attorney to draft a tailor-made NDA for each negotiation. Businesses may also feel pressured to act quickly, precluding the realistic possibility of retaining an attorney. (Confidentiality agreements and nondisclosure agreements, or NDAs, are terms that are used in this post interchangeably.)

Because of these factors, many companies will dust off a creaky form received years ago or execute a blind-googled form. The risks of the practice are apparent: these forms may overly restrict a a party through backdoor provisions, such as non-competes, or fail to provide the disclosing party with the expected level of protection.

This situation results in a fair amount of hand-wringing on the part of attorneys, but it’s not about to change in the near future. As a help to those businesses who execute NDAs as per the above, I’ve prepared a cheat sheet of confidentiality agreement concepts that should appear in a confidentiality agreement. There’s an abundance of trashy quality (though free!) contracts on the Internet; I hope, at the very least, that the below might help users identify them.

For the list below, I assume we are dealing with the sharing of information by a target company to a potential acquirer, so there will be terms related to a “proposed transaction” and the NDA will be a one-way (as opposed to where both parties are sharing information).

1. General restrictions. The receiving party should be restricted from (a) disclosing confidential information and (b) using the confidential information for any purpose other than evaluating the proposed transaction. Almost every NDA includes the first restriction, but a surprising number simply neglect restrictions on use.

2. Definition of “confidential information.” This definition will be the subject of some negotiation. The disclosing party will seek to include a broad definition, like “all information relating to the disclosing party disclosed to the receiving party.” The receiving party may not want to shoulder this burden and seek to narrow the definition by requiring “confidential information” to be marked as such by the disclosing party.

In reviewing the confidential information, the receiving party will often seek to manipulate the data so it can better be analyzed. The definition of “confidential information” must include all such studies and analyses created by the receiving party using the information described in the previous paragraph.

3. Exclusions from the definition of confidential information. Four basic classes:

information that is or becomes public other than as a result of disclosure by receiving party
information that can be shown by written evidence to have been known by the receiving party
information that becomes available to the receiving party from a source other than the disclosing party or parties prohibited from disclosing the information
information independently developed by receiving party

4. Permitted disclosures. In order to evaluate the proposed transaction, the receiving party will have to share the information with its advisors and certain employees. The receiving party must inform these advisors of the confidential nature of the information and require these individuals to sign NDAs. In the event of a violation by any such advisor of its confidentiality obligations will be deemed to be a breach of the receiving party of its obligations per the NDA.

5. Disclosure required by law. If required pursuant to a court order, the receiving party may disclose confidential information, but only to the extent required and should make efforts to obtain confidential treatment for the information.

6. Return of confidential information. At the end of the disclosing period, the receiving party must return all the confidential information, including copies or analyses, etc.

7. No warranty. An affirmative statement by the disclosing party that it makes no warranty that the information is accurate or complete. If the parties proceed to a definitive agreement, that agreement will contain representations and warranties related to the business.

8. No obligation to proceed. The mere fact that the parties entered into this NDA, does not give rise to the obligation to sign a definitive agreement.

9. No grant of IP rights. The NDA does not give the receiving party the right to license any intellectual property contained in the confidential information. [As an aside, an NDA is generally an inappropriate form to restrict an entity from competing or soliciting. The receiving party should ensure the NDA does not contain any such language.]

10. Enforcement. A statement that breach by the receiving party will entitle disclosing party to equitable, in addition to legal, remedies. Equitable remedies include a preliminary injunction to stop a party from acting in a certain way. Money damages may not be an adequate remedy. (Arguably, the disclosing party would have the right to pursue an injunction even if the agreement lacked this language.) Receiving party must inform disclosing party if there has been any violation of the NDA.

There are pragmatic issues related to enforcement of NDAs: the disclosing party is not always aware of a breach of a confidentiality agreement. Also, especially with respect to startups, a company may have a very low appetite for a litigation to enforce the agreement. If that’s the case, why bother signing up an NDA?

First, hopefully, a party is not entering a negotiating with an unsavory character and relying exclusively on the terms of the written agreement. Due consideration should be paid to the trustworthiness of your counterparty, as well as to the drafting of your agreement. This will hopefully reduce the chances of breach.

Perhaps even more importantly, signing an NDA with your counterparty helps to generally maintain the status of your confidential information as trade secrets. Courts will typically protect the secrecy of information deemed to be “trade secrets.” In order to qualify as trade secrets, the information must be kept secret or, if the information is communicated to a third party, the third party must be pledged to secrecy. The NDA serves as this pledge and your trade secrets will still, hopefully, be afforded the general protection of the courts with respect to your trade secrets.

Rule of thumb: Don’t enter into an NDA immediately. Go on a first date. Speak in generalities, not specifics. See if there is a degree of trust. If there’s some ‘there’ there, then enter into an NDA.

One more thing: Ken Adams, a former colleague of mine, great guy and ninja-precise drafter, offers an automated NDA generator on his website. I’ve seen a sample of the product, and am happy to endorse it. The price for a single NDA: $50. Check it out: http://www.koncision.com/.

Risk of Receiving Membership Interests as Compensation, NY LLC Edition

Wed, 24 Aug 2011 12:33:00 -0400

Graphic designers, programmers, and other service providers may be presented with an opportunity to be compensated with membership interests in a New York limited liability company. This prospect allows these service providers to share in the upside of many startups companies.

Setting aside for the moment the host of complex tax issues raised by this practice, I’d like to presently talk about a much neglected section of the NY LLC law that could have adverse consequences on an unsuspecting service provider.

Companies issuing membership interests will, either in its operating agreement or in the servicer’s consulting agreement, usually restrict a service provider’s ability to compete with the company’s business and solicit its customers and employees. With a typical consulting agreement, with services paid in cash, the restrictions will last for the period the consultant is working on the project, and, perhaps, an additional period following the end of the assignment. However, when a service provider is issued membership interests as compensation, these restrictions may last as long as the service provider remains a member of the company.

This last point can create significant issues for a service provider. Turns out, it’s not that easy to stop being a member in a NY LLC.

According to NY law, unless a company’s operating agreement states otherwise, members may not withdraw from an LLC. Couple that with the fact that most startup LLC’s prohibit without consent the transfers of membership interests, in many NY companies it’s near-impossible to give up membership interests.

All this means that, even if a service provider fully and satisfactorily completed the contracted-for tasks, a recipient of membership interests may, for a lengthy period, be restricted in what business activities he or she can participate. Unless a servicer obtains the requisite company consent, this restriction period can conceivably last as long as the life of the LLC. Membership interests, initially so coveted, can quickly become an albatross a service provider might be willing to throw off for little or no consideration at all.

This trap can be sprung on even the most careful service providers who properly examine a company’s operating agreement prior to the issuance of membership interests. NY law states that members are not permitted to withdraw even if a company’s operating agreement is silent. This is just the NY default.

As an aside, I should note that employees have successfully challenged in NY courts the length of noncompete and other restrictions. However, these rulings were in connection with employment agreements, which contain an inherent power disparity between the parties. I’ve yet to see a service provider/LLC member challenge the length of such restrictions. While NY courts may analogize this situation to that of employees, no one really knows how a court will react.

Bottom line: From a company’s perspective, restricting a service provider’s ability to compete may make perfect sense. But restricting the right of service providers after the engagement is completed, plus perhaps a tail period, seems over-reaching. With respect to such service provider members, operating agreements ought to clearly spell out the length and sunset of restrictive covenants. And for the member service providers, beware!

Risks of Issuing Membership Interests as Compensation

Tue, 23 Aug 2011 15:28:00 -0400

Cash-strapped startups are often faced with the issue of how to adequately incent service providers. In order to reduce cash compensation obligations, and to align the servicer’s interests with those of the business, companies frequently opt to issue equity.

The practice of issuing equity in exchange for services implicates a number of complex legal and accounting issues. I’d like to focus here on a couple of the tax consequences to a service provider compensated with membership interests of a limited liability company. I should add that, for the sake of brevity, this post contains overgeneralizations related to the tax code.

An issuance of membership interests to a service provider gives rise to two taxable events from the service provider’s perspective:

1. Upon receiving membership interests, the servicer will be liable to pay taxes on the fair market value of the membership interests less the amount paid for them, if any. Servicers’ receiving membership interests subject to vesting will be liable for this tax on each vesting date, unless they file a Section 83(b) election which allows them to pay this tax on the date of the initial agreement (with a presumably lower fair market value).

This tax regime is substantially similar to that of a service provider granted shares of stock in a c-corporation.

2. The second tax liability arises out of the specific nature of the LLC, which is taxed a partnership. Members are required to annually pay taxes on earnings of the LLC—regardless of whether the LLC actually distributes out any of these earnings to its members. A service provider could therefore be in a position of paying taxes for money he or she never received. This is especially an issue with startups: typically, startups look to retain earnings in order to grow the business. The tax liability could come as a unpleasant surprise to unwitting service providers.

To make up for this treatment, some LLC’s will agree in its operating agreement to reimburse each member for this tax liability. But this mitigates one of the underlying reasons of granting membership interests to service providers: to reduce costs. Companies who do not pick up this expense may cut against the other rationale: that of adequately incenting service providers. At the very least, lack of disclosure of the tax treatment may very well lead to distrust between the service provider and LLC. management.

Bottom line: The tax regime related to LLC’s make incenting service providers with membership interests a less attractive proposition than corporations.

Note (added 8/23/11 5:01p): The above post holds true with respect to “capital interests,” membership interests having the right to proceeds when and if the Company is sold. With respect to “profits interests,” membership interests not entitling its holder to a share of proceeds in a sale of the company, the treatment is less certain. The uncertainty is yet another reason issuing membership interests is less than optimal for equity compensation.