Starting An Online or Web Based Business – Legal Issues To Consider
|Prepared By: Melissa C. Marsh, Los Angeles Business Attorney
Written: May 2000
Selecting the Correct Legal Entity.
All new ventures should consider how it will be organized, i.e. the correct legal entity to operate the business. Many entrepreneurs assume that forming a tax efficient entity, such as an S corporation or Limited Liability Company ("LLC"), in their home state is the most sensible choice. The fact of the matter is, depending on both the short and long term goals of the business, it may be better to incorporate in a different state and adopt one legal entity over another.
For instance, as a general rule, if the business intends to raise venture capital financing in the near future (say, within a year), a corporate entity that is most suited to venture capital financing (such as a C corporation incorporated in either the state of California or Delaware) may be the better choice. Venture capitalists invariably require numerous controls and restrictions over a company to protect their investment and usually will insist on investing in a corporate entity formed in a state where there is a substantial corporate governance law (such as California and Delaware). Corporations are particularly attractive to venture capitalists because of the relative ease with which preferred series of securities can be created to attract investors and yet still preserve the ability to offer favorably priced options to employees.
There are, however, many tax considerations which should also be considered and these may override the financing considerations, particularly if investor capital is not going to be sought for some time. However, many Internet start ups bypass traditional growth and financing models because of the need to move at "Internet speed" and to raise significant investment capital immediately to build market share in a new area of commerce. For these companies, choosing the wrong corporate entity can lead to unfortunate delays and legal, tax and cost disadvantages involved in switching from an existing corporate entity to one preferred by investors.
Founders Agreement - Commitment to the Venture.
It is also very important to ensure that the founders of the new business are like minded when it comes to their relative interests in the business and their commitment. It is the new venture's equity which drives founders to give their all to the venture and thus how that equity is initially divided and held is critical.
A Founders Agreement deals with such issues as the relative split of the equity between the founders and how long they have to serve the company for this interest to fully vest. Generally it is important that all founders be subject to vesting as this helps ensure continued commitment to the company. In the event one of the founders leaves, the remaining founders will need the departing founder's equity to offer to a replacement.
However, you should consult in advance with your tax advisors with regard to any vesting restrictions for the founders as there are some important tax considerations to consider (for instance, the potential need for the IRS filing commonly referred to as an "83(b) election").
The Founders Agreement would also commonly control the ways and means in which the founders exercise their voting rights and any transfer or sale of their interest in the venture.
With so many new ventures springing up on the Internet and so many new opportunities for entrepreneurs, it is all the more important to tie in your fellow founders to the cause. With the potential for significant and even meteoric rises in valuations for Internet ventures, it is more important than ever to get the right tax treatment for founders' stock.
Stock Options - Give Away Pieces of the Company Carefully.
One of the most common problem areas facing start-ups is stock option grants and plans. It is essential for any Internet start-up to create a stock option plan that creates a "currency" to attract and retain qualified employees. Competition for these employees is particularly fierce and equity incentives (perhaps even more than cash and benefits) are a deciding factor in attracting new talent. It can also be important in attracting the services of high level consultants to the company for specialist duties, as has been the case recently with Priceline.com who obtained the services of the well known actor William Shatner as a spokesperson, in part through providing him with rights to purchase the company's stock. However, there are many pitfalls for the unaware or poorly advised.
Some of the most problematic issues are created by well intentioned promises to give an employee "a percentage of the company" without any thought to vesting, diluted effects of raising investment capital and tax and accounting treatment. These vague promises often result in acrimonious and expensive disputes that usually cost the venture much more than a well prepared stock option plan.
Stock options are also securities and thus compliance with federal and the relevant state securities laws have to be considered. Again with the speed at which Internet companies take off, it is easy to overlook the need to build a solid and fair basis on which employees can participate in the venture. With Internet start-up ventures often having employees distributed all over the country (and even the world), there is often a broader set of securities laws to consider.
Company Name and Branding.
It is often the case that when a new venture announces to the world "I'm Company X", a series of other companies in succession announce "No, I'm Company X". This confusion as to who is who usually stems from a failure of the new venture to properly pre-screen and then protect its company name and brands. With the advent of the Internet, this issue has taken on an added level of complexity in terms of domain names and the means by which users locate a venture's presence on the Internet (currently a "URL", which stands for Uniform Resource Locator).
The prudent thing to do when starting a new venture is to choose a company name and brand that meets your marketing goals and which is shown by comprehensive searches to be available for use. Many preliminary, screening searches can be conducted for free or for little expense. A preliminary search of the federal online register will help one ascertain whether there is already someone else trading under the name you are considering.
It is also essential to search on the Network Solutions Web site to determine the availability of and to reserve the desired URL (and the most obvious derivative versions of such URL). If such preliminary searches are successful, further levels of searching should be conducted to confirm the availability of the name as a trademark and corporate name, and then once an available name has been chosen, steps should be taken to reserve such name as a corporate name with the relevant Secretary of State, to register it as a federal trademark and reserve a broader range of derivative versions of the URL.
The costs of securing a clear trademark and domain name position will be much higher if protective steps are not taken until after the brand has been built. This has been illustrated by the many cases of "cyber squatting" where an opportunist has launched a Web site with a URL that includes a famous brand, and then sought to hold the brand owner hostage. Also, as many Internet companies are plowing much of their available funds and equity into funding extensive advertising campaigns, it is essential that the business' trademark and domain name position be secured to the greatest extent possible before significant dollars are devoted to such advertising.
Placements - the Value of Real Estate on Web Sites.
While there are many established practices of providing payment for endorsements or advertising space, none have the functionality, variability or characteristics of placements on Web sites. Here are some common issues associated with such placements:
- Where Does the Placement Go? New start-ups should focus on the terms of the agreements they reach with alliance partners and "affiliates" to ensure there is clarity as to exactly what type of placement and prominence will be given or received. For instance, is the placement going to be graphical and/or textual? Will it be a hypertext link to another Web site or a co-branded area? Where on the Web site will it appear? What size will it be (usually determined in terms of number of pixels)? Clarity is often hard to reach, in part because of the technical variables involved (e.g. browser software can create different displays of the same Web page; the size of the user's monitor can determine how much of a page appears "above the fold"). One good practice is to develop prototype pages that illustrate the intended placement and then attach those pages to the contract as an example.
- Ever Changing Business Plans. New start ups should also carefully consider the escape clauses in any contract. Internet businesses have a habit of changing their business plans almost overnight and it may be that your alliance partner or affiliate will become your competitor. Or, through merger or acquisition, your placements may be suddenly on the Web site of a company owned by your rival. It is therefore important to try to seek flexibility in any contractual arrangement, such as through rights of termination.
- Changing Value of the Real Estate. The placements you sell today may be worth more later, so carefully consider your exit strategies for any placement arrangements.
Another common set of problems that arise with new Internet ventures is the proliferation of overlapping commitments to business partners. Often, to secure a new relationship, funding, or customer, a start-up will give exclusivity commitments and/or commitments not to offer more favorable commercial terms to other parties (the latter is often referred to as a "Most Favored Nation" or MFN provision). Following are some common pitfalls:
- Overlapping Exclusives. In the rush to establish new alliances or affiliations, a start-up should not promise the same exclusive arrangements to more than one party, which will constitute a breach of its contractual commitment to both parties. Exclusives should be carefully and concisely drawn and limited in a readily identifiable way (e.g. duration, type of content, type of customer, language).. A new venture should establish a central process for controlling and tracking the grant of exclusive and non-exclusive (as a non-exclusive placements) which may preclude the grant of a later exclusive commitment and should keep good records of its contracts.
- Exclusive To The Grantor Too. Another common mistake made is to act on the misconception that an exclusive commitment still allows the grantor to exercise the same rights. Unless the contrary is clearly stated in the relevant contract, an exclusive commitment is generally interpreted as to the exclusion of everyone else, including the grantor itself.
- Ambiguous MFNs. Again, in the desire to move quickly, start-ups are prone to committing to ill conceived and poorly drafted MFN provisions. These provisions can cause considerable problems when the business later tries to determine if the MFN provision has been triggered. Also, where there are multiple MFN provisions extended by a new venture, the complications are compounded by the need to provide everyone "most favored pricing." To the extent that MFNs have to be given, try to make them as narrow as possible, so that the provision only applies to completely comparable products or services, with like parameters (such as volume and price), require that the party exercising the MFN right take all the terms and conditions that the other party took as part of the comparable arrangement (e.g. the other party may have accepted less onerous warranties and indemnities) and ensure that the provision is not retroactive.
The full importance of the data collected at Web sites and the impact of FTC vigilance and existing and potential regulation has become a major issue for all new Internet businesses. One of the key issues for a new Internet company is to educate itself on the current and likely future laws and to build data collection and management functions that comply with the law and build for the future. Many existing Net businesses are stuck with trying to determine how, if at all, they can use the data they have already collected without explaining to the data subjects how and why the data was collected. A new Internet company has an opportunity to take a better approach and to build data collection and management processes that anticipate later uses for the data and ask for the data subjects' permission for such use.
The Likely Impact of Patents for Business Processes.
Although the determination that business processes are appropriate subject matter for patent protection impact all potential new companies, the impact is likely to be particularly hard felt in the Internet and e-commerce arenas. This is due in part to the fact that the Internet, by its very nature, presents a tool by which innovative new methods of doing business can be developed and deployed. There is now a heightened need for new Internet companies to analyze the patent terrain and the potential for patent protection and infringement. Patents might be an extremely potent weapon against your competitors, if your patents cover a part of the competitor's business. The threat of litigation alone may make it difficult for your competitors to raise their own capital. If in turn your venture receives a claim of patent infringement from a third party, having your own arsenal of patents may be useful in responding to such threats, as you can offer cross-licensing arrangements as a potential resolution of their claim. The key is to seek the counseling of patent counsel before disclosure of the new business process or product to others in the absence of a confidentiality agreement and promptly after the development of the business process or product.
Reliance on Outsourcing.
To execute on new opportunities quickly and to avoid the costs associated with developing non-core competencies internally, many new Internet start-ups outsource some, if not a majority, of their functions. This very often concerns the hosting and maintenance of its presence on the Web, which is obviously of critical importance. Some of the most important legal issues associated with any information technology outsourcing relationship include: control, security, back-up, disaster recovery, and exit rights.
There are many new twists on the traditional legal issues that any new business faces, and resolution of such issues requires an in depth understanding of the business, technology and applicable law, as well as a good deal of planning and preparation.
© 2000 Melissa C. Marsh. All Rights Reserved.