STOCK ISSUANCE FOR STARTUPS: How To Do The Right Thing?

By: Chujia Yu

        One of the most important legal issues that startups face after incorporation is issuing stock to its co-founders.  To avoid legal problems rising in later years, co-founders should consider: (1) how to allocate stock shares amongst co-founders; (2) when is the best time to issue stock; and (3) how to value stock after the business builds in value. 

How to allocate stock shares among co-founders?

        Many startups would automatically divide the equity equally among the co-founders without further consideration.  This is a big mistake.  Equity division is a significant decision for the corporation not only because it will assign certain percentages of ownership to each founder, but also because it is a good timing to clarify the roles and expectations of each founder effectively.  Although there is never a “clean cut,” the co-founders should negotiate each of their respective percentage of the ownership based on the contribution of each co-founder and their short-term and long-term roles. 

        In addition, the startup should leave enough of its authorized shares unissued as a reserve for bringing on additional founders or investors, and for employee stock option plans.  It is a good practice for the corporation to only issue 50% to 80% of its authorized shares of common stock to the co-founders at the time of incorporation.

When is the best time to issue stock to the founders?

        One of the common mistakes that startups make is that co-founders think they have already split the ownership after they signed a founder’s agreement to divide the ownership of the future company.  The co-founders will not readdress this issue after entity formation because they think they have already dealt with it.  However, in order to acquire that certain percentage of ownership of the corporation, the founders need to pay the matching price of the shares.  The basic rule about stock issuance is that whenever the stock is issued, it always needs to be priced at fair market value.  At the time of incorporation, the corporation generally has no assets or revenue and thus is worth little.  Founders need only pay for the shares at the price of par value (often at $ 0.0001 per share) of the stock set out in the articles of incorporation. 

        Failing to issue stock to themselves in this early stage will make founders suffer a lot economically.  As time passes, the corporation will build in value quickly, especially when it begins to earn revenue and has attracted outside investment.  Therefore, the fair market value of the company’s stock at this moment would be much higher.  Although there are alternatives for founders to acquire stock than direct purchase, those alternatives have some disadvantages as well.  One alternative is to grant the founders the right to purchase the stock at a discount, which seems like a good solution at first glance.  However, founders will be required by Internal Revenue Service (“IRS”) to pay the income tax for the discount part.  The other alternative is to grant stock options to the founders.  However, since options do not carry voting rights, founders’ ability to influence the corporation prior to exercise of those options will be limited. 

        In addition, failing to issue stock at this stage would greatly hinder any attempts at fundraising down the line.  In determining whether a corporation is worthy of the investment, high-quality investors would typically consider whether the corporation has established a vesting schedule for its founders and issued stock to the founders.  Therefore, it is the best practice for the corporation to formally issue stock to the founders at the time of the incorporation, subject to vesting.

Stock valuation after the business builds in value

        For those corporations that failed to issue stock to co-founders at the time of incorporation, they normally have two approaches to decide the purchase price.  One approach is to randomly pick a number.  However, doing so would trigger tax implications by IRS and would cause auditing problems.  The other approach is to calculate the fair market value of the stock at that moment.  The most theoretically sound method for stock valuation is the discounted cash flow model (“DCF”).

        The discounted cash flow model is a type of absolute valuation models.  Absolute valuation models aim to find the intrinsic or true value of the stock based only on fundamental elements, which include dividends, cash flow and growth rate of the corporation.  In a sense, the discounted cash flow model uses the company’s discounted future cash flows to value the business (an investment now is worth an amount equal to the sum of all the future cash flow it will produce, with each of those cash flows being discounted to their present value).  To use this model, the company is required to have positive predictable free cash flows, which requires the company to have more operating cash flows than capital expenditures in a given year.

        The equation for this model is:

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In the equation above, “DCF” is the sum of all future discounted cash flows, which is the fair market value of the corporation.  “CF” is the positive cash flow for a given year.  “r” is the rate of return to investors.  “n” is the number of years.  Take the following hypothetical to help illustrate the above equation.  Suppose XCorp. has an annual growth rate of 10%, $ 10 million positive cash flows per year, and a compounded annual rate of return to the shareholders of 20%. 

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        Thus, the discounted cash flow in all future years would be the first year’s cash flow of $ 10 million divided by 120% (1+20%), plus the second year’s cash flow of $ 11 million [$ 10 m *(1+10%)] divided by 120% squared (1.2*1.2), plus the third year’s cash flow divided by… In deciding upon the discounted cash flow method for stock valuation, co-founders can choose the variable “n” they deem to be suitable to represent the future growth of the company (some will choose to run the “n” to infinity using certain software, some will choose a certain number, e.g., 25 years).  When co-founders get the number of DCF, they can divide the DCF by the number of authorized shares to determine the value of the stock. 

        To conclude, it is best practice for a corporation to issue 50% to 80% shares of common stock to the co-founders at the time of incorporation for lower price.  Otherwise, they have to apply the complex DCF method to determine the fair market price of the stock in order to avoid triggering the tax implication by IRS.

 

GOING PUBLIC: Two Different Routes, Two Different Goals

By: EIC Student

            Raising capital is a challenge for almost every entrepreneur during his or her business’s lifecycle.  The capital required, or even simply desired, to grow a business may exceed what individual private investors are willing or able to give.  Constantly finding new private investors can drain a company of time and resources.  A popular remedy for this dilemma is for an entrepreneur to take the company “public,” aka to sell its stock to public investors in the open market.  There are a number of advantages to going public: the financial benefit of immediate capital, ease in raising capital later, increased public awareness of the company and its brand, and even the potential for an exit down the road.

            The typical route for going public is an Initial Public Offering (IPO).  However, there is another method that has reemerged in light of a recent rule change with the NYSE: the direct listing process (DLP). 

WHAT IS AN IPO

            An IPO is the most common option for companies looking to go public.  In an IPO, companies work with a number of intermediaries to facilitate the process of meeting the regulatory requirements to be listed on an exchange (like on the NYSE or NASDAQ).  One of those intermediaries are underwriters. In an IPO, underwriters assist in meeting statutory and market requirements, and in preventing financial harm to the company.  Underwriters’ work culminates in setting the initial offering price.  Underwriters also buy the shares from the company first and then sell to investors via their pre-existing distribution networks that are comprised of investment banks, brokers, dealers, and mutual funds. These connections to distribution networks help underwriters to set realistic IPO prices and ensure that company stock is bought by long-term holders.  Additionally, underwriters can provide for a guarantee of sale to their clients, adding a level of security for the company going public.  The downside of an IPO is that underwriters and other intermediaries (e.g. investment bankers, etc.) charge a fee for their work.  Usually this is between 2% and 8% of the capital raised via the IPO.  While underwriters will take care of the process and formalities, it comes at a cost that can be burdensome to entrepreneurs who are searching for funds to begin with.

WHAT IS DLP

            In addition to an IPO, companies can go public through a DLP.  In a DLP, a business, rather than using a number of third parties to run the process, will sell shares directly to the public.  No new shares are issued; only existing shares can be sold.  This prevents dilution to existing stocks and gets rid of additional steps the company would have to take.  A DLP also does not have a “lock-up period,” or a time when stockholders are restricted from selling their own shares in the market due to contractual terms. 

            This begs the question – how does a company make any money from an DLP?  The short answer is: they don’t.  One financial benefit of the DLP is that it gives shareholders a way to make money immediately on their own.  It gives the investors of a company the ability to sell stocks as soon as the company is listed and do it on a larger, transparent, regulated market.  Individual shareholders can make money.  But, the longer answer that demonstrates the benefit to the company’s finances is the ability for the company to later grow, authorize, and issue shares with less hassle.  Existing as a public company facilitates raising capital and obtaining financing in the future; a public company can conduct a second offering to raise capital, and the access to capital markets provides a better route to future funding sources.

            DLP is also appealing to small businesses looking to enter the public market because of the low cost attached to a DLP; there is no underwriter fee and no broker fee.  If a company has low funds to begin with, spending the extra money on an IPO and all the fanfare attached may seem unnecessary.

            However, there are downsides to using a DLP.  The first, as previously mentioned, is that the company does not raise capital immediately.  Additionally, unlike in an IPO, there is no guarantee for the sale of stock and this risk only increases with the absence of promotions or safe long-term investors.  Further hurting the company’s prospects is the inability for greenshoe options.  A greenshoe option is a clause contained in the underwriting agreement that allows underwriters to purchase company shares at the offering price so that if public demand for the shares exceeds expectations and the stock trades at a higher price, the brokers are permitted to sell more shares.  Once the additional shares are sold in the market, the broker can buy them back and stabilize fluctuating share prices.  This is a key benefit to having the intermediary resources available in an IPO; the networks that make IPOs appealing are absent from a DLP.  Lastly, if the company is in need of immediate financing, a DLP is less appealing.

THE LEGAL REQUIREMENTS

            To file for a direct listing with the NYSE, a company must file with the SEC a registration statement that it has declared “effective” and that covers the resale of some or all of the outstanding shares of its restricted stock.  For a U.S. issuer, this can be done on a Form S-1, the same form used to register for a traditional IPO.  Additionally, when filing for a direct listing, a company can choose to register under the Securities Exchange Act of 1934 using Form 10 (or Form 20-F(R) for foreign private issuers).

This form is subject to review and comment by the SEC and also requires a number of disclosures about the company akin to those of a IPO registration statement which includes information regarding the company’s management and finances.  The direct listing is not effective until it has received SEC approval. Additionally, the NYSE has qualitative criteria and quantitative criteria that must be satisfied in order to be listed; these still hold when applying for a DLP. 

RESURGANCE OF THE DLP: SPOTIFY

            Spotify is a music streaming site and app available for free to consumers. It has 159 million users, 71 million of whom are paying subscribers of Spotify Premium.   Though a private company, Spotify announced its intentions to go public via a DLP, a particularly rate move, and it officially went public on April 3rd.  As a larger tech company, the traditional move would have been an IPO in the vein of Facebook’s 2012 IPO or Snapchat’s 2017 IPO.

During its 2018 Investor Day presentation, Spotify went into further detail as to why it is departing from the typical route.  First, Spotify noted the ability to list without selling shares.  Spotify is without debt since it converted debt into equity for investors.  Currently, it has approximately $1.3 billion in cash and securities, and is turning out a net profit.  The company has no need to immediately issue large quantities of new shares.  Second, Spotify noted the democratic nature of the liquidity aspect within the context of a DLP; employees and investors can sell at any time and are not stuck in a lock-up period.  Third, bankers will not be getting preferred access; everyone has the opportunity to purchase shares at the same time.  Fourth, Spotify noted the ability for all people to have the same information about the company.  Lastly, Spotify believes in market-driven price discovery (i.e. allowing for the public to determine what the company is worth rather than select financiers).

While Spotify’s stated reasoning romanticizes the market place as capable of regulating fair value for its stock, the choice to avoid an IPO is still risky for the company.  At its core, Spotify is a music app.  Music prices and catalogues are similar across the industry.  Without the benefits of publicity and fanfare that come with an IPO, it was unclear how Spotify would do.  However, the DLP date has passed and there are concrete numbers to be considered.  Spotify’s DLP was successful; Spotify yielded a public market value of about $26.5 billion (above its private market value) and had a first day closing price of $149.01, higher than the reference price set by the NYSE based on the data available from previous private market trades.  Though, by the morning of April 4th Spotify shares had dropped as much as 8.5%, opening at $140, this should still be seen as a success from the perspective of private companies looking to go public, but perhaps a potential threat to traditional Wall Street mainstays.

BEHIND THE TIMES: WHERE TRADEMARK LAW AND CROWDFUNDING DISCONNECT

By: Zach Fountas

The Value of Trademarks

In an increasingly digital age, it is not surprising that a company’s most valuable property may in fact be intangible. A trademark is a word, name, or symbol used to identify a source of goods or services and differentiate them from goods or services of competitors. Though trademarks originated as a way to identify the source of goods, and therefore, the quality of the product, they have evolved to have their own independent value as brands. Nike’s “swoosh” is a prominent trademark consumers look for when they want to purchase a quality sweatshirt. The logic is simple; Nike –  a leading clothing manufacturer – has established goodwill with consumers by consistently selling quality products. By putting the trademark “swoosh” on their products, a consumer purchasing that product does so with a preexisting understanding of the product’s quality.

However, if the extent of a trademark’s value is identifying who produced the good, then why is a lower quality sweatshirt with the words “Harvard University” across the chest often the same price as a Nike sweatshirt? Harvard, unlike Nike, is not known for its textiles nor did the university manufacture the sweatshirt. Why then does the value of the sweatshirt increase when a Harvard trademark is added? The value increases because today branding is business and an association or affiliation with a famous brand has value independent of the quality or source of the goods.

In a world of constant advertising and a need for yearly growth only brand name recognition, and the loyalty accompanying it, can ensure the success of an emerging company. According to the market-research company Millward Brown, brand equity accounts for at least 30% of the value of companies listed on the S&P 500 index. This isn’t surprising. According to investsnips.com, McDonald’s – among the most successful brands in American history – has a stock price around $150, while competitors like Jack in the Box and Wendy’s have stock valuations of around $85 and $17 respectively. The value discrepancies are not because McDonald’s has burgers that are twice the quality of Jack in the Box or nearly nine times better than Wendy’s. The discrepancies rest largely on the customer loyalty developed by McDonald’s over the past 60 years.

So, Let’s Trademark Our Brand!

With such a significant value, it is important to register your trademark as soon you can. As noted here, early registration of your mark prevents others from using the same or similar mark for their products and begins the process of brand recognition. Applications for registering a federal trademark fall under 15 U.S. Code §1051(a) which requires:

1.      The trademark must be filed for by the person or entity that actually controls the quality of the goods and services.

2.      The applicant must specify what type of entity and the citizenship or domicile.

3.      That the mark is used in commerce.

The third element, “use in commerce” is difficult for many startups to meet, particularly those relying on crowdfunding campaigns. The Trademark Manual of Examining Procedure §901.1 (TMEP) defines use in commerce as a “bona fide use of a mark in the ordinary course of trade, and not made merely to reserve a right in a mark.” It further states that the mark must be placed on the goods, containers, displays or otherwise associated with the goods and that the goods must be sold or transported in commerce. Unfortunately, 70 years after the enactment of the Lanham Act, businesses no longer have the luxury of a sheltered slow and steady growth towards prominence, unthreatened by competitors from every corner of the country. As a result, trademarks need to be secured as soon as possible.

The Crowdfunding Problem        

Crowdfunding has become a staple strategy of many emerging companies in an attempt to create, or corner, a market before competitors have a chance to draw consumers away. Emerging companies that utilize crowdfunding as a way for validating their product concept, and raising the necessary capital to deliver the product, have a problem. The product they are advertising needs a name, the name needs to stay the same from when they advertise the product on a platform such as Kickstarter to the time it is delivered to backers, and that name needs to be a unique brand to build around. Ideally, a company could trademark the name once their Kickstarter campaign webpage was up and running. The TMEP §904.3(i) states that:

A web page that displays a product can constitute a “display associated with the goods” if it:

1.      contains a picture or textual description of the identified goods;

2.      shows the mark in association with the goods; and

3.      provides a means for ordering the identified goods.

Unfortunately, as lizerbramlaw.com notes, this does not satisfy the second requirement of “use in commerce” defined earlier in this blog. In addition to a display associated with the goods bearing the trademark, the goods themselves must be “sold or transported in commerce” as stipulated in §901.1 of the TMEP. Further, TMEP 904.03(i)(D) expressly stipulates that the USPTO must reject specimens of displays on beta websites – a website displaying a preliminary version of a product or service – if there is no “evidence of use of the applied-for mark in commerce.” As discussed earlier, use in commerce requires a bona fide use, which generally eliminates prototypes from being evidence of use of the applied-for mark.

As a result, it is unlikely that a Kickstarter campaign would constitute actual use in commerce. Ignoring, for the moment, whether a successfully funded Kickstarter campaign could be argued to be a pre-sale of a product and thus “in commerce”, we should first consider campaigns that are just beginning. As described in Kickstarter’s FAQs, pledges to campaigns that are unsuccessful are refunded to backers. Therefore, until a campaign is successful and meets its capital raising goal, there is no actual agreement between the company and the backers to exchange funding for a product. Without outstanding performance required on both sides (payment on one side, delivery of product on the other), no sale has truly occurred, let alone commerce.

Even if a project on Kickstarter is backed and has met its fundraising goal, it is still uncertain as to whether the pledges in connection with the product idea and desired trademark have been constructively “sold in commerce” as a presale. In fact, lawyers focused on the legal issues surrounding crowdfunding video games bemoan the fact “that the USPTO does not consider a successful crowdfunding campaign to be a use in commerce.”

Does Filing an Intent-to-Use Solve the Problem? 

Rather than filing for a trademark currently in use, emerging companies using crowdfunding could file their desired mark under 15 U.S. Code §1051(b) with an intent to use the mark. In this respect, a company may essentially reserve a mark prior to its use in commerce. However, intent to use (ITU) filings, instead of actual use filings, have additional costs, both monetary and non-monetary. There are more filing fees with an ITU application since applicants must pay to amend their filing to allege use once the product is in commerce. Also, until the applicant has used the mark in commerce and alleged that use to the USPTO, there is no right to sue for trademark infringement.

            Although filing an ITU application helps an emerging company that is trying to get off the ground through crowdfunding, it is not a perfect solution. Notwithstanding the additional monetary costs inherent in an ITU application, the protection only extends the time for a company to demonstrate use in commerce by approximately 9 months, unless the USPTO grants an extension. After filing the ITU, the USPTO will issue a Notice of Allowance (NOA) within 12 weeks if no party files an opposition. Once the NOA has issued, the applicant has 6 months to file an additional Statement of Use, certifying that the mark has been used in commerce. Failure to do so will result in the abandonment of the trademark filing.

Conclusion

            It is clear that filing an intent-to-use application can buy emerging companies some time in their quest to secure a trademark, but it is not long. Companies that want security in knowing their mark will be registered (absent issues regarding protectable subject matter, distinctiveness, and functionality) must plan ahead. Prior to debuting a mark on a crowdfunding campaign, a company should consider the length of time their campaign will be open to meet its fundraising goal, and how quickly after the closing of a successful campaign the company can produce and send its first shipment of product. If the timeline for such a feat is shorter than 9-months, the company should file for a trademark under intent-to-use. If the projected timeline is longer, the company must consider whether they believe they could successfully receive an extension from the USPTO, or whether they want to hold off on debuting their mark in association with the goods until a later date.    

Protective Provisions versus Board Designations: How Entrepreneurs Can Give Up Control to Venture Capitalists in the Most Strategic Way

By: Tyler Mills

            This blog post seeks to alert entrepreneurs to a process by which to strategically give up control to venture capitalists. Because it is inevitable that some control of the venture must be given up to institutional investors, an entrepreneur should calculate how to deliver control to venture capitalists in the most beneficial way. This post will address two common mechanisms that VCs employ to obtain control—protective provisions and board designations—and then will argue that, if given the choice, entrepreneurs should favor granting VCs board designation rights over protective provisions.

First, Why Entrepreneurs Have to Give Up Some Control to VCs

Entrepreneurs may be wondering why they have to give up some control to the VCs. Venture capitalists seek control of the startups in which they invest because of the agency problems inherent in such companies. Agency is a legal relationship where one party, the principal, grants authority to another party, the agent, to act on the principal’s behalf. In the venture capital context, the agency relationship looks like this: The VC infuses the company with capital and in return the entrepreneur acts on behalf of the VC to ensure that his/her money is being put to good use, i.e. working towards increasing the company’s value. However, information asymmetries between venture capital investors and startup entrepreneurs create agency problems, which VCs try to mitigate by securing a degree of control of the company. The agency risks of venture capital financing typically come in two flavors: adverse selection and moral hazard.

First, adverse selection risks result from hidden information. For example, venture capitalists may be unable to sufficiently determine the viability of the entrepreneur’s invention or business and the entrepreneur’s work ethic. The entrepreneur, on the other hand, is in a better position to know about these risks. Second, moral hazard risks are associated with hidden actions. For example, because an entrepreneur’s human capital is so crucial to the success of the business, an entrepreneur can threaten to quit or perform poorly, after a VC’s initial investment. This will force a VC to renegotiate terms or insert more capital. Because of the above-mentioned information asymmetries inherent in venture capital financing, venture capitalists will often seek control of the companies in which they invest. In seeking control, venture capitalists often choose between two strategies: protective provisions and board designations. Entrepreneurs should be familiar with the above-mentioned two strategies so that they can give up some control in a beneficial way.

Second, Entrepreneurs Should Know Venture Capitalists’ Strategies to Obtain Control

When investing in startups, venture capitalists will use a few common mechanisms to secure control. First, VCs will typically only invest in preferred stock because of the large contractual nature of that type of stock. When VCs contract for preferred stock, they will negotiate zealously for protective provisions, which give them veto rights over certain corporate actions, such as selling the company or raising capital. By negotiating for these protective provisions, venture capitalists are able to control the companies in which they invest in order to increase the likelihood of a return on their investment.

            In addition to protective provisions, venture capitalists will typically negotiate for the right to designate one or more individuals to the company’s board of directors. The board of directors of a company establishes policies for corporate management and makes major decisions for the company. In addition, a company’s board of directors, at least in Delaware, is given great deference via the business judgment presumption and Section 141(a) of the Delaware General Corporation Law. As a result, venture capitalists can control major corporate decision making through their board designees, most importantly decisions relating to sale or initial public offering, the two preferred mechanisms for securing a return on investment.

Inherent Defect of Board Designation Strategy: Fiduciary Obligations

Members of a company’s board of directors owe fiduciary obligations to the company’s stockholders. A fiduciary obligation is “the obligation or trust imposed by law on officials of an organization making them liable for the proper use and disbursement of the organization's money, funds and property.” The main fiduciary obligations owed to stockholders by board members include the duty of loyalty, duty of care, and duty of good faith (which is typically categorized as a subset of the duty of loyalty). These duties ensure that the company’s board is acting in an informed manner and in the best interests of the company and its stockholders, rather than acting in their own self-interest.

In In re Trados, the Delaware Chancery Court dealt with the question of a board’s fiduciary obligations in the context of a VC-controlled board. In Trados, the Chancery Court held that when a preferred-controlled board favors the interests of preferred stockholders over those of common stockholders in deciding whether to enter into a transaction, the board will be left with the burden of proving that the transaction was “entirely fair” to the company. This holding tells us two things. First, a VC-controlled board owes fiduciary obligations to common and preferred stockholders alike. Second, if a VC-controlled board decides to favor the interests of preferred stockholders over those of the common, the board will lose the business judgment presumption and have to prove the entire fairness of the transaction. The entire fairness standard is Delaware’s most stringent standard of review, which seeks to determine if the process for determining whether to enter into a transaction and the price at which the transaction was entered into, were fair. As a result of this holding, entrepreneurs now have more clear safeguards against VC investors’ control via their board appointees. 

A Recommendation for Entrepreneurs: If Given the Choice, Permit Board Designation Over Granting Protective Provisions

            Because VC-controlled board members owe fiduciary obligations to common stockholders to not favor the interests of preferred-stockholders, this blog post recommends that if forced to choose between granting VCs board designees or conceding more protective provisions, entrepreneurs should choose to grant board control. The reason for this is because, particularly after Trados, it is clear that board members must not favor preferred stockholders’ interests over those of the common or risk having to prove the entire fairness of the transaction. This ruling gives entrepreneurs greater safeguards to protect against venture capital domination if they grant board control. On the other hand, protective provisions are contractual in nature and, as such, do not provide the same legal safeguards as the fiduciary obligations discussed above. 

 

 

STARTUPS AND TRADEMARKS: THE CONFUSION AROUND LIKELIHOOD OF CONFUSION

By: Gabriella Falcone

One of the first steps in forming a business is filing a trademark application to protect the company name.  For many, the trademark is registered with no complications.  Others, however, will receive what is called a USPTO Office Action, with one of the most dreaded Office Actions being for “likelihood of confusion.”  [1] In this instance, thoughts of panic race through the mind of the entrepreneur: “What does this mean?  Do I need to come up with a new business name?”  The good news is, not necessarily.

Likelihood of Confusion Simplified

Trademark registration is governed by the Lanham Act, which bars trademark registration of applied-for-marks if such registration would confuse or deceive a consumer as to the source of the goods or services offered by the applicant of the mark.  [2] The reason the USPTO may reject a trademark application for likelihood of confusion stems down to the fact that they believe the applied-for-mark may cause confusion to consumers with a trademark that is already registered to another owner.  The confusion issue does not relate to the trademarks themselves, rather it relates to confusion about goods or services because of the trademarks placed on them.  [3] Stated simply, the USPTO wants to prevent consumers from being tricked into thinking that they are purchasing a good or service from an established, registered trademark holding brand when they are in reality making a purchase from a completely unrelated party.  This is a valid concern and also happens to be the core policy rationale surrounding trademark law, but when taken into consideration with how many registered trademarks exist, one may find it seemingly impossible to come up with a trademark idea that is not at least moderately similar to someone else’s.  It becomes even more frustrating when trying to find the fine line at which this similarity will be considered potentially confusing.

The Analysis

When analyzing likelihood of confusion between two trademarks, the USPTO and courts apply a multi-factor test.  In the litigation scenario, factors relevant to the likelihood of confusion analysis will differ depending on which state and court is conducting the analysis.  However, in the trademark application process, the leading case for likelihood of confusion established thirteen factors relevant to a likelihood of confusion analysis.  [4] Factors relevant to this inquiry include:

1.      Similarity of the marks

2.      Similarity of the goods or services in connection with the marks

3.      Similarity of trade channels used

4.      Care used by buyers when purchasing

5.      Fame of the registered mark

6.      Number and nature of similar marks in use on similar goods

7.      Nature and extent of actual confusion

8.      Length of time during which the marks have been concurrently used without evidence of actual confusion

9.      Variety of goods on which a mark is used

10.  Market interface between the applicant’s mark and the registered mark

11.  Extent to which the applicant has a right to exclude others from use of its mark

12.  Extent of potential confusion

13.  Any other facts probative of the effect of use

The most determinative of each of the factors are (1) the similarity in the marks in their sight, sound, and commercial meaning; and (2) the relatedness of the goods or services described in the marks.  [5] For example, consider the hypothetical scenario in which Starwood, a major hotel chain has a registered trademark in their name, and a lumber and building company called Star Wood applies for their own trademark.  Applying the two major factors, the two marks look similar in their spelling, and only differ by the space in between the two words.  They also sound the same, because they are in fact identical words.  However, as to the second factor, the goods and services offered by the two companies are completely unrelated, as Starwood offers hotel stays and related goods and services, and Star Wood offers lumber and building services.  Even though the names themselves are essentially identical, the fact that the goods and services offered by the two companies are not at all related could weigh in favor of Star Wood registering their trademark. 

How to Overcome a Likelihood of Confusion Rejection

The easiest way for a startup to avoid a likelihood of confusion rejection is to prevent the rejection altogether.  Startups can, with or without legal counsel, conduct trademark searches on the Internet and USPTO database to trace registered trademarks that have the potential to be confusingly similar to their idea.  Doing so creates assurance and peace of mind that, before investing valuable time and financial resources into the trademark registration process, it is actually possible and likely that the trademark can be registered in the first place.  This, however, is easier said than done, and a trademark search does not always reveal every potential confusingly similar culprit. 

In the instance where a trademark search does not reveal a similar mark, yet the USPTO rejects the trademark application anyway, it does not necessarily mean that the trademark can never be registered.  It just means that the applicant will have to do some additional research and work in convincing the USPTO Examining Attorney that the marks are actually different from one another.  To do so, a startup’s best option is to hire an attorney that will submit a convincing argument to the USPTO stating the various reasons why the two marks are, in reality, not likely to be confused with each other.  This can be done by applying the relevant factors, with a particular emphasis on the two most important factors of the marks’ similarity, and the relatedness of the goods and services they cover.  This requires extensive research of the opposing owner’s business, and the products and/or services that they offer.  It is crucial to understand who they are and what they offer in order to make effective and accurate arguments against confusion with the mark that they own.  Additionally, it is equally as important for the applicant to clearly articulate the details of their own business and the products and services that they offer.

Conclusion

Startups have many legal issues to worry about when getting their businesses off the ground, the most daunting being doing everything possible to choose and protect their name with minimal funds.  A likelihood of confusion trademark rejection is intimidating, and certainly does not help ease the startup tension.  It is important to realize, however, that even if a mark is initially rejected, it does not mean the end of the road for that name is approaching.  In many cases, there are options and ways to overcome the rejection; startups just have to know how to do so.

Entity Formation: Starting Points for Tech Startups

By: Eitan Davis

A few months ago, you woke up with an idea for a product or service that would fill a gap in the market. You googled sporadically for days only to find that, interestingly enough, no one seemed to have arrived upon the same idea. And so, you set off to build it out. Countless hours behind your respective building table later, you’re finally sitting behind a minimum viable product, casually pitching its utility to anyone who will listen. The response is positive and you’re starting to gain some traction. “This might actually take off,” you muse. As your 4th cup of coffee reaches room temperature, you realize it’s time to form an entity. At this point, you’re familiar with the names and basic functions of the various business types, but where can you find the benefit in forming an LLC over a C-Corporation, or vice versa? Are there any drawbacks? Will your choice prevent you from actualizing some future ambition? Which is right for you?

This is a necessary crossroad for every startup. The implications can be substantial, since the entity type the business takes on can greatly affect the future growth and viability of the company as a whole. Though a little daunting at first, the proper path tends to become clearer when some important preliminary questions are answered.

The Two Basic Types of Business Entities

Each entity is similar in that it serves to limit the liability of its owners in various degrees. However, they differ largely in their corresponding tax treatment.

LLC

An LLC is a “pass through” entity taxed as a partnership. Each owner (“member”) pays tax on the income they receive through the LLC in accordance to their share of profits or losses, the proportions of which are determined by the LLC agreement. In the case that there is a sole member, the LLC would be treated as a “disregarded entity” and the LLC’s total losses and profits would be included on the sole member’s personal tax return. Like a corporation, the LLC can be created with provisions allocating different classes of ownership with customizable rights. Since relatively few formalities are required for its annual maintenance, LLCs are also generally easier to set up and maintain than C-Corps.

C-Corporation

Unlike an LLC, a C-Corporation is a distinct entity for tax purposes, subject to federal income tax that is paid through the entity on its income. Unless the corporation pays dividends to its stockholder, the stockholder will not incur tax liability on the earnings of the corporation. There are numerous other tax implications that may prove advantageous down the line.

Whereas ownership of an LLC can be divided among its members in the proportions allocated in (or later amended to) the operating agreement, ownership of a corporation is issued in the form of shares of the company, to any number of stockholders. However, the number of shares issued does not necessarily represent a fixed percentage of ownership that is guaranteed to last throughout the lifetime of the corporation. For example, say your corporation authorizes 100 shares at formation. Soon after, it issues 25 shares to each you and your partner, for a total of 50 shares issued, making you 50-50 owners. Later on, in a subsequent round of funding, you issue the remaining 50 authorized shares to an angel investor while retaining your 25 each. The change in the total issued shares from 50 to 100 is immediately reflected in your ownership of the corporation, taking you from a 50% owner down to a 25% owner. Dilution of a corporation showcases the conventional importance of keeping as much of your equity as you can while fundraising.

Why most startups should (and most often do) opt to form a C-Corp

Investors

Perhaps the most important and least technical reason for forming a C-Corp rather than an LLC is simply that investors prefer and expect it. Taking on membership in an LLC would complicate an investor’s personal tax liability, where they would be taxed on the company’s earnings even when those earnings are being reinvested into the company, regardless of whether or not any cash has been distributed. Indeed, some venture capital firms are prohibited entirely from investing in pass-through entities like LLCs because they are comprised of tax-exempt partners whose positions could be compromised by active business income. With a C-Corp, an early stage investor simply acquires a capital asset (stock) and only deals with tax implications upon its sale, where the capital gain or loss event occurs.

Special Tax Treatment

The Section 1202 reduction in capital gains tax for qualified small businesses (“QSBS”) allows “an individual taxpayer (to) exclude 50% (and sometimes more) of the gain realized on the sale of a QSBS stock if the taxpayer holds the stock for more than 5 years prior to sale. The taxpayer can also defer recognition of gains if the taxpayer reinvests in QSBS within specified time parameters.” This yields a potentially huge advantage to investors in it for the long haul and is unavailable for investments in LLCs.

Liability

For investors and founders alike, there is well-developed corporate case law – largely stemming from the Delaware courts - in whose jurisdiction most American corporations are formed. Precedent predominantly favors business and provides many safeguards protecting officers and board members from being held liable for the business’s actions. While this body of law does extend to LLCs, the extent of that reach is in many ways still unclear. The overwhelming focus has been and continues to be the C-corporation.

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When it comes down to it, for startups – particularly in tech – whose objectives involve rapid growth, equity grants, multiple rounds of fundraising, reinvestment of capital and, ultimately, an initial public offering, the C-Corp presents structural advantages that make it the clear choice for many founders.

CAUTION! Fiscal Sponsorship Agreements – An Alternative to Seeking 501(c)(3) Status

By: Eitan Davis

Growth, in its many iterations, is a common focus among most entrepreneurs. On the other hand, profit, though related, can sometimes be a mere afterthought to effecting the core mission of the project.

Fledgling nonprofit organizations with limited funding may find difficulty in making the most of their incoming capital, especially in consideration of the myriad measures that need be met in order to achieve tax-exempt status.  To obtain 501(c)(3) status, an organization begins by filing IRS Form 1023.  The requirements are many, and, at nearly 30 pages itself, Form 1023 is lengthy, commonly requiring an additional 20 pages of attachments.  The cautious (and deep-pocketed) entrepreneur can afford to reorganize and seek help through costly consultation with accountants and attorneys.  However, founders whose circumstance dictates a more economical approach, or those with more finite project-durations, may benefit by seeking fiscal sponsorship from reputable, established nonprofits in their space.  To that end, a chief concern is choosing the right sponsor.

What is Fiscal Sponsorship? 

In a fiscal sponsorship relationship, an existing nonprofit organization (sponsor) confers its tax-exempt and/or legal status to the sponsoree so that the sponsoree can take on grants and donations that it could not otherwise receive – all of which must be in conjunction with activities related to the organization’s mission, and the specific purpose of the project being sponsored.  Without having to adjust its status (e.g., from an LLC to a nonprofit corporation), a smaller charitable project is able to utilize the name, tax treatment, and other unique administrative services offered by the sponsor.  These arrangements typically involve certain administrative services, covered by the sponsor, who recoups a portion of these costs by requiring a fee in the range of about 5-15% to be “paid back” by the sponsoree on any funds received.

Two Common Forms of Fiscal Sponsorship

The Direct Project

In a Direct Project model, the founding members of a project approach the sponsor with an original program idea.  Once adopted, the project is taken in-house and made an extension of the sponsor holding no separate legal entity.  Essentially, the project would be no different than any of the other activities engaged in by the sponsor directly, even though, in theory, it would be operated by its founding members.  The members conducting the project then take on an employer-employee relationship whereby the sponsor both owns the results of the project outright, and also takes on total liability for the acts of its new employees.

Preapproved Grant Relationship

In a Preapproved Grant Relationship, the project remains a separate legal entity from the sponsor, which allows founders more control over the project’s operations.  A grantor-grantee relationship is established, limiting the sponsor’s liability to 3rd parties, as opposed to the employer-employee relationship found in the Direct Project model.  Here, the project would specifically outline its intended activities in an application for one or a series of grants from a sponsor.  If an agreement is made, the project would then go on to solicit donors who would make contributions to the sponsor on behalf of the project. After this point, the sponsor would disburse funding to the project respectively.  Donations can be one-off or ongoing, according to the provisions of the contract.

Maintaining Control

Typically, the founders of a project will need to give up a degree of discretion and control (outlined in contract) in order to enjoy the benefits of a fiscal sponsorship.  Sponsors who fall into the two categories above are, at the very least, fiscally responsible for the projects they engage.  That liability requires that they exercise more or less complete control over a project’s funds, ensuring that funding is used for only for proper project purposes.  Unwanted tax liabilities may be incurred if it is found that funds have been used by the project for substantially private benefit.  The sponsor’s necessity for oversight is made far more pressing when, as in the Direct Project model, a project becomes an integral part of the sponsor, holds no separate legal identity, and imposes liability on the sponsor for all of the acts of those working conducting the project.

Even where the project isn’t a separate legal entity, founders will still sacrifice some elements of practical autonomy.  Take for example the project who seeks to engage in fundraising activity for a political candidate.  The sponsor’s liability makes it unlikely that they will allow the activity because 1) the candidate may not align, either personally or politically, with the sponsor’s mission, and 2) tax implications having to do with fiscal sponsorship require that funds specifically advance the project’s objective, and prohibit substantially private benefit.  Were the IRS to determine that involvement in political fundraising does not advance the objective initially laid out in the fiscal sponsorship agreement, and then the project channels funds raised from such activity through the sponsor, legal issues would likely arise.

This isn’t to say that the sponsor will be dictating what you can and can’t do at every move. It is however important to bear in mind that, one way or another, your project will be subject to certain limitations of control, which can differ greatly depending on the model of sponsorship you seek, and the particular sponsor with whom you engage.

Know Thine Sponsor

Any number of reasonable hypotheticals will clearly emphasize the importance of choosing the right fiscal sponsor.  To that end, consider whether your proposed sponsor is right for you.  Research and due diligence are integral to making this determination.  Is the sponsor in good standing in their respective community?  Are they well-funded?  How have they treated past fiscal sponsorees?  Have they afforded a great deal of autonomy or been (by your standards) overly conservative in their operations?  Also consider how your sponsor has communicated their expectations for this project in particular – do they expect ownership or are they merely acting as an incubator to help get you off your feet?

As with any impactful contract, before committing, make sure the terms and parties align with your vision for your project.  Fiscal sponsorship agreements often take longer than a few weeks to hash out, and you shouldn't feel rushed into signing anything until you’ve received satisfactory answers to all of the questions you’ve thought to ask.