Crowdfunding is going to continue to explode in the near future. On March 25, 2015, the SEC adopted new rules to implement the provisions of the JOBS Act and Regulation A surrounding raising capital up to $50 million by smaller companies and, most likely, raise that money online on their websites or through social media. (The rules don’t go into effect until 60 days after they are published in the Federal Register and here is a copy of the rules and the SEC Press Release). The new changes have been called “Regulation A+” and hailed by many as significant improvements in giving smaller companies more access to capital.
There are requirements for certain disclosures and filings with the SEC as well as registration of the websites with the SEC as funding portals like a securities “broker-dealer.” There are also tiers for the companies that depend upon factors like the amount of money raised and state what the requirements will be for each tier. The end result is that you are going to see much more investment opportunities on the internet and social media geared towards everyday consumers without the requirement that they be classified by higher wealth or income as “accredited investors”, so caveat emptor and let the buyer beware!
For those who aren’t sure, what exactly is “Crowdfunding”? Most of the discussion in this area involves securities laws. When a company needs to raise money, they may offer an investment in the company by way of stock, LLC units, convertible debt, or other investments. These are all securities covered by US and State law and regulated primarily by the US Securities and Exchange Commission. The company does not need to be a publicly traded stock like a Facebook or Microsoft to worry about the SEC and state regulators. Any company or person offering or selling stock or other “security” can be subject to regulation. When companies want to raise capital without the expense of registering their stock with the SEC, they rely upon exemptions from registration. Most of those exemptions limit companies to seeking investors who meet the definition of “accredited investors.” These are basically people with over a $1 million net worth or whose income is over $200,000. Smaller investors are often kept out of these investments by rules designed to protect them assuming that they don’t have the financial savvy to protect themselves. Crowdfunding is an effort to raise money for a company or a cause from a large number of investors each investing a small amount of money. It was difficult to use crowdfunding to seek investors for a company if you were limited to only finding “accredited investors” and fall under an exemption from registration. The provisions of the JOBS Act and the rules that the SEC is issuing are meant to expand access to capital for smaller companies. Part of the provisions of the JOBS Act were to allow and expand the use of crowdfunding. Instead of a company raising $250,000 by seeking $25,000 each from 10 accredited investors, the company will now try to raise $250 each from 1,000 regular investors.
It is hard to know the future impact of crowdfunding and the JOBS Act’s attempts to increase access to capital due to many possible areas for possible fraud or misleading of investors. It looks like the SEC is going to keep a close eye on this topic and they are taking years to be sure the rules implementing the JOBS Act from 2012 cover all possible problems. We will have to wait and see the impact, but it seems like many smaller companies will be able to gain access to previously difficult to obtain capital.
Many entrepreneurs and founders are hesitant to talk to an attorney for fear of the dreaded hourly billing or unknown costs. The other concern is that many people fear or don’t want to deal with lawyers, either because they don’t know what to expect or there have been bad experiences they have experienced or have heard about. That is why many people avoid getting initial legal work complete when they are working on a startup idea. Learn more
I was reading an article in this month’s (June 2012) Entrepreneur magazine by Ann C. Logue entitled “Beyond the Handshake- Having a business partner can be valuable. Having the wrong-or no-partnership agreements can be disastrous.” It details the experiences I hear every day by founders, entrepreneurs, and startups. Most know they need quality legal and business advice in the early stages of their growth, but don’t want to spend the money on it. With the advent of online document and template sharing, discount legal document prep companies, and companies out there like LegalZoom and RocketLawyer offering low-cost or free legal documents, I very often hear and see the impact that is having. I have worked both in the trenches of many a cash-poor startup and also as an attorney advising these same type of companies or founders and wanted to give some additional guidance and solutions from both perspectives.
Education and information are some of the most critical areas for any start-up. They need to know their product, know their market, learn how to commercialize their product or service, and how to go from idea to a functioning business. I put together a handbook with some of the common areas operationally, administratively, financially, and legally in my Startup Bootcamp 101 e-Book (Click to download free pdf) to provide some basic education on those aspects of business start-ups. There are web resources that I have tried to compile as well at this Blog, but there are tons of resources in the form of books and online materials. Some recommended books are Venture Deals by Brad Feld, the Lean Startup by Eric Reis, and the Startup of You by Reid Hoffman. I will discuss some of the do’s and don’ts when trying to stay within a “lean startup” mentality, but also when you do yourself a disservice by trying to cut corners to save money.
A common question asked by start-ups or even just average average businesses is what information they can ask or use in vetting their potential employees. Some common forms used may be background checks, drug screening, and reference checks. Due to the economy creating many credit problems for average citizens (even more so with entrepreneurs who often use their own personal credit to bootstrap their company), I will take a look at the use of credit reports in making employment related decisions.
Existing federal law provides that, subject to certain exceptions, an employer may not get a credit report without prior disclosure of that the employer wants to obtain one and the employee consents. Existing federal law further requires, subject to certain exceptions, an employer, before taking any adverse action based on the report, to provide the consumer with a copy of the report and a written description of certain rights of the consumer.
California enacted AB 22 which amended California Civil Code Section 1785.20.5 to provide additional protections in this state to protect the potential employee when dealing with similar uses of credit reports. This law went into effect January 1, 2012. In addition the California Labor Code added Chapter 3.6 to include additional requirements. The law provides that the employer needs to follow the same federal requirements of disclosure that they want to obtain a credit report, but also requires the employer to state why they want it. The law goes on to further indicate that credit reports can only be requested for the following certain categories of types of positions (except by certain financial institutions): Learn more
Many small business owners or other entrepreneurs start out with a great idea for a new product or service. They start a business and focus on doing whatever it takes to make the company successful. Many don’t take the steps necessary to properly protect the business from creditors or don’t really pay much attention to what they sign when they are making deals. The ones who do read the fine print may just have the attitude that they are so confident in the business’ success, who cares if they use their own personal credit to get some working capital. With the economic downturn over the last few years, many business owners have had to close their doors because they couldn’t get the funds they needed to even cover the simple things like payroll or rent.
Use of Personal Credit
Many entrepreneurs feel that they should put some ‘skin in the game’ by contributing some of their own money into the business. In fact, the Small Business Administration backed loans often require the founders to contribute at least a certain percent of their own assets or some other major contribution in order to qualify for a business loan. When the owner doesn’t have available cash, they look to other sources to get the money to contribute. That can lead to things like taking out a home equity line of credit or using personal credit cards to help fund the business. Obviously that is pretty risky, but often necessary to get early access to this seed money to start and grow. The banks that issued the credit did so based upon the owner’s personal credit rating. Just because the credit card may have the business’ name on it doesn’t mean the bank hasn’t covered their bases by making sure they can sue the owner personally if the business defaults in payment.
So a major issue faced by many startup founders, especially when they are bootstrapping, self-funded, or just watching their cash, is how they can get legal or other services with little to no cash. The fall back position is to give the advisor or service provider a “piece of the action.” The founder often wants to use stock in the company they formed or stock options to avoid using cash, but still obtain needed advice and guidance. Here are the main problems you will run into:
1) Valuation– You will have a difficult time agreeing on a valuation of the company’s stock (see Section on Valuation). The founder often feels that they have the next greatest invention or idea of all time and the company is already worth billions despite having no business model or revenue (just watch an episode of Shark Tank on ABC). The valuation is what you use to determine the value of the stock in comparison to what the services are worth. (e.g. 1,000 shares of stock valued at $1 per share in exchange for $1,000 worth of services) The service provider or advisor may have a different idea of what your company or idea is really worth. If you can’t come to some agreement on the value of the stock, you won’t get them to sign on.
One of the biggest questions small business owners or founders have when it comes to early stage business issues is when do they need to hire an attorney and how do they pick one. I will explain what I think are important qualities and how an attorney can be invaluable, even before the company is formed.
A good startup (some people spell start-up, some use startup) or business attorney needs to be able to see a wide variety of potential issues the company may face and be able to address those with the company or founders. If they simply form a corporation and provide some initial shareholder agreements, bylaws, resolutions, or other initial documentation, that is a valuable service, but there is much more to be examined and addressed in an early stage business. There are many legal or business issues, such as what intellectual property protection is or needs to be in place (e.g. patents, trademarks, non-disclosure agreements), advise the founders about securities laws relating to issuing stock or raising money, preparing for human resources and hiring (e.g. explaining that you can’t just call someone an independent contractor or 1099 and avoid payroll tax withholding obligations), and when to get someone involved in drafting or reviewing contracts. While it is true that “startup law” is really mostly about basic formation and protection of business entities and possibly help with closing initial rounds of funding, the attorney should have a wide general knowledge of many aspects of business and law.
In this day of a new app being developed every day, how does the company owner or management know who owns the code developed and when they could lose control over it?
Most issues of ownership for software code fall into areas of copyright (a form of intellectual property or IP), since they are usually “written works of authorship” and primarily covered by US copyright law. Copyright protection provides the author with protection from reproduction by others. There are times when works can be reproduced without violating a copyright under things such as the “fair-use doctrine,” such as when sample pages from a book are reprinted in a blog with commentary by the blog author about their thoughts or criticisms about what is being said in the book. The rights for copyright protection are generally given to the original author of the work for long periods of time (anywhere from 70 years to over 120 years depending upon all the facts). After that amount of time has passed, the work is considered in the public domain and others can copy it without worrying about infringement.
When someone starts a company, they usually have an idea or vision and a passion to bring that idea or vision to market. Many founders get stuck in a difficult spot that most commonly comes up in the process of raising money. This is what I call a double-edged sword for startup founders, i.e. ownership and control of the company.
Many founders start to form a deep bond with their ideas and visions that are embodied in their new company. They take ownership of those ideas and the company. During the growth phase, they are asked to slowly give up some control of that company, usually through dilution of their ownership % by private sales of stock. One major identified reason that startups face major problems and may result in the company failing is the inability to give up control when the company starts to grow. New investors are coming in to get an ownership stake at a very risky stage in a pre-revenue company in exchange for potentially very high rewards. Part of what investors look for in investments are the ideas or vision, management team, and the passion of that team to drive the company to growth. If the founders are only focused on an exit where they go public or are acquired and retire early rich, investors will be put off by those founders who seem to care more about their own personal wealth than having a successful company. If Mark Zuckerberg would have pitched to investors that he was going to take Facebook public and make the company’s stock worth billions within two years, he would probably not have gotten many of those early investors, at least the experienced ones.
Part VI) Internet & Tech Company IP Protection
So you are working on the hottest new startup and want to know how to protect your ideas when you are out raising money and recruiting new engineers and designers. Here is a brief overview of the types of intellectual property (IP), ways to protect them, and tips for your startup. I will focus on some of the more common issues in internet and tech related companies, although some of these issues appear in other contexts. This information is meant to be an educational overview only and should not be used as a substitute for legal advice or considered an exhaustive discussion of all IP issues. Facts & circumstances can vary, as do laws and regulations by state or other territory, so you should consult with a local licensed attorney to be sure you are properly protected.
Copyright is a protection for original works of authorship that must be tangible. You can’t use copyright protection to protect an idea until that idea is put into a tangible form. The most common ideas people have of copyright is usually with authors who write film scripts or books where they often see the words “copyright” or a c with a circle around it and things like the name of the author and year next to it. The idea of the book is not protected by copyright law, it is when the book is written is when it becomes tangible and subject to copyright laws. In the internet and software context, source and object code can be protected under copyright laws if they are an expression of an idea, not if they are simply the idea themselves.