Equity Crowdfunding 101: Is It For You?

By: Ji-Su Park

April 2017

Everyone has an idea. Everyone has a story to tell. But turning that story into a successful business takes commitment, know-how, and capital. Raising capital is challenging at any stage of a company’s growth but it is especially more difficult for startups that are at the earliest stages of development when the business model is still under construction.

Fortunately, for startups today, there are many options for raising funds. In the last year or two, ways to fund a business have significantly changed. More and more companies today are considering an online public offering, also known as “equity crowdfunding,” as a way to support their business in addition to more commonly known options such as debt, angel, or venture capital funding.

To help you decide whether or not equity crowdfunding is right for your business, this post looks into the background and history of crowdfunding and equity crowdfunding and analyzes the pros and cons of equity crowdfunding.

What is Crowdfunding?

Professor C. Steven Bradford, a leading scholar on the issue of crowdfunding at the University of Nebraska College of Law, defines crowdfunding as “rais[ing] money through relatively small contributions from a large number of people.”[1] Crowdfunding involves getting individuals to pool their resources to finance a project without a typical financial intermediary such as a bank or an underwriter.[2] The individual investors often do not engage in crowdfunding for financial gain; in fact, they often act more like donors. If the amount pledged is met by the investors, then the investors usually receive something in return, such as a product from the business (e.g. a DVD or CD from the film or album produced).

Today, in a typical crowdfunding transaction, an entrepreneur goes onto a crowdfunding website such as Kiva, Kickstarter, GoFundMe, and Indiegogo and proposes the amount needed for the project. Clearly, the Internet enables an entrepreneur to sell to millions of potential investors in real time with no incremental cost.[3] In other words, anyone who can convince the public to believe that he or she has a good business idea can become an entrepreneur, and anyone with a few dollars to spend can become an investor.

What is “Equity Crowdfunding”?

While the concept of the Internet-based crowdfunding itself is not so new, “equity crowdfunding” is a step beyond the earlier crowdfunding models. Because crowdfunding used to be limited to all but equity crowdfunding, the only way small businesses generally could access the capital of the masses used to be through an initial public offering (“IPO”).[4] However, for most small businesses, the average cost of going public was extremely expensive. The cost of going public for a small business in the United States is between $100,000 and $1.5 million in third-party fees. This naturally isolated the public from the small businesses.

When Congress finally decided to take action to cure this problem, it looked at the success of the traditional crowdfunding option popularized by websites such as Kickstarter, Kiva, GoFundMe, and Indiegogo and contemplated the use of equity-based crowdfunding, which was already being popularized in Europe. In April of 2012, President Barack Obama signed the Jumpstart Our Business Startups Act (“JOBS Act”), which received bipartisan support from the bill’s inception.[5]

By establishing new registration exemptions for equity crowdfunding under Title III, the JOBS Act eliminated the excessively restrictive requirements for small businesses to access capital. While drafting the JOBS Act, Congress theorized that equity crowdfunding would democratize the investment process and provide small businesses the necessary funds to survive through recession and eventually prosper.[6]

Equity crowdfunding allows startups to raise cash from non-professional investors who get a stake in the company. Non-professional investors invest in a project in exchange for equity: they give money to the venture and get shares in the venture. According to the Securities and Exchanges Commission (SEC) rules, investors with an annual income or net worth of at least $100,000 can invest up to 10% of the lesser of those, up to $100,000, in a 12-month period. Investors who fall below that mark can invest the greater of $2,000 or 5% of their annual income or net worth in a 12-month period. If the project succeeds, the value of the shares goes up and benefits the investors. If the project does not succeed, the investors lose as the value of their shares goes down.

What Are the Pros and Cons of Equity Crowdfunding?

Pros

●       Access to capital

○       A larger pool of investors: Both professional and non-professional investors have the chance to invest in your company. Given the wide reach of the Internet, you, the entrepreneur, have the chance to reach out to a larger pool of investors who might be looking for exciting young businesses.

○       Attracting additional sources of funding: Crowdfunding and other sources of funding are not mutually exclusive. You can pave the way for future funding by leveraging a successful campaign and making your company more attractive to big investors.

●       Control

○       Setting your own terms: You determine your company valuation, the number of shares to issue, and the minimum investment amount.

○       Retaining company control: You do not have to provide preferred stock or board seats.

●       Increased visibility and brand equity

○       Marketing: This modern, democratic approach to funding a company can increase visibility and brand equity through the marketing efforts of your campaign.

Cons

●       Legal issues

○       It’s new and complicated: There are a lot of new rules and regulations around equity crowdfunding. Making sure that you are following the law will take a lot of time and money, including getting the proper legal advice for your business.

○       Ongoing reporting requirements: Doing an online public offering requires filing with the SEC. It is important to consider any ongoing costs and annual reporting requirements.

●       Control

○       Keeping the investors happy: It is great to raise a lot of money from so many different people but remember that with equity crowdfunding, these people have ownership, too. That means that you need to keep these investors updated and satisfied, and eventually -- if all goes well -- paid, if your business succeeds in the future.

○       Facing angry investors: Furthermore, some investors may also be very vocal in their opinions about how you run the business. Taking money from investors can be stressful when you have to manage pretty demanding investors. It is definitely different when you are giving equity away as opposed to the traditional rewards-based model of crowdfunding.

●       Real effort required

○       Lack of expertise: Many investors you find from the crowd are unlikely to add value to your business beyond their cash. This means that you could be missing out on the experience and mentorship that sometimes come with other forms of funding such as angel or venture capitalists, most of who have been in your shoes in the past. Therefore, equity crowdfunding might not make sense for the entrepreneurs who need business mentors and advice to succeed, or who need industry expertise from investors to open doors to opportunities.

○       Cost: While there is no set amount that a campaign will cost you, there are some marketing costs to consider, such as costs of videowork or artwork to push your message out to the public.

Is Equity Crowdfunding Right For You?

Ultimately, this is a question you have to answer for yourself.

According to a report from The Forum of for Sustainable and Responsible Investment (USSIF), millennials, or the young generation born roughly between 1980 and 2000, “have shown particular interest in producing a positive impact on society through their investments.” As these millennials continue to age and start investing, there might be more potential in equity crowdfunding as a financing option for socially impactful startups. In fact, some of the most successful companies with equity crowdfunding have been companies in socially progressive areas such as cleantech, green tech, transportation, health and fitness, and healthcare. These companies already have had a pre-existing online footprint and established a like-minded community before jumping into equity crowdfunding.

It must be noted that equity crowdfunding is not just a U.S. innovation. Though equity crowdfunding may be new to the U.S., other countries -- especially the European countries such as Switzerland, Sweden, Italy, and the U.K. -- already have been using this model of crowdfunding for years.[7] Today, there is a global trend towards the legalization of equity crowdfunding: the equity crowdfunding legislation passed the Australian Senate in March 2017, and South Korea adopted the equity crowdfunding model in January 2016.

As we see equity crowdfunding legislation being considered and adopted across the world, it is likely that experiences from the success of equity crowdfunding will lead to further reforms in the future.

[1] C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 10 (2012).

[2] Andrew J. Sherman, Raising Capital: Get the Money You Need to Grow Your Business 95 (2012).

[3] Bradford, supra note 1.

[4] Christian W. Borek, Regulation a+: Navigating Equity-Based Crowdfunding Under Title IV of the Jobs Act, 47 Cumb. L. Rev. 143, 144-45 (2017).

[5] Id.

[6] Id.

[7] Id.

Fitness trackers & health information – I’ve walked 6,000 steps, but who else knows it?

By: Kathryn Pajak

April 2017

It was the middle of the night, I was walking back and forth through my apartment determined to get to 10,000 steps.  Sound familiar?  The new fitness trend of wearables has taken the millennial generation by storm (and basically all other generations at that).  But – what does this fitness tracker really track?  The GPS measures how far I’ve walked, but does it track where I was? Where is that information stored?  Can a court subpoena the information?

Fitness trackers have swept the world. A Pricewaterhouse Coopers study found that one in five American adults owns a wearable device, and the research firm Canalys reported that eight million activity-tracking bands were expected to ship in 2014.  Fitness trackers hold great promise for public health policy and personal wellness.  The main contenders in the market are Jawbone (site and privacy policy), Fitbit (site and privacy policy), and Garmin (site and privacy policy).  The challenge fitness tracker and mobile health apps face is striking a balance between collecting necessary information and protecting consumers’ privacy.  Fitness tracker manufacturers require consumer trust to sell their products; they know they cannot sell their products if their customers don’t have confidence that the manufacturers have reasonable privacy protections and data security in place.

What Information is Collected?

Companies Collect Personal Fitness Information (“PFI”) – PFI consists of various types of sensitive information such as a user’s heart rate, number of steps taken, activity levels, sleep quality and duration, and calories burned.  Not only do these devices collect PFI, but also they collect a large volume of it. Data gathered from fitness trackers likely has broader public health implications for researchers and policy makers.  For instance, at some point, such data could be as detailed as a doctor’s medical records, and such information could be shared with employers, insurers and financial professionals. The sale of the aggregate PFI data may ultimately implicate HIPAA thereby imploring lawmakers to update HIPAA or pass new legislation.  It could even fall under the reach of the Fair Credit Reporting Act if it is used to make employment or credit offers.

How is it Collected?

Sensors and Algorithms – Fitness trackers function by collecting information via sensors that measure motion, specifically the acceleration, frequency, duration, intensity and patterns of your movement.  The data collected is transformed into steps and activity.

Fitness Trackers Function on Sharing – When using fitness trackers, individuals voluntarily share their private information.  This directly contrasts traditional privacy concerns of third-party surveillance, because users of fitness trackers voluntarily record and transmit their lives in granular detail. Therefore the privacy issue at hand is not whether users are being recorded, but rather what happens to the data collected.  There seems to be a general lack of awareness from users on how much, and how potentially harmful, the data collected is. 

Who has Access?

It isn’t Clear Who has Access to the Information Collected – Naturally companies and fitness brands, which collect this information, have access.  However, recently, these companies have been selling the information to the highest bidder. 

What are the Potential Legal Issues?

Fitness Trackers are Under Attack in Europe – The laws in Europe are traditionally stricter on privacy than the laws in the United States.  In fact, recently the Norwegian Consumer Council accused health tracker manufactures of violating European law because the Council is concerned that none of the companies give users proper notice about changes in their terms, all of the wristbands collect more data than what is necessary to provide the service, none of the companies fully explain who they may share user data with, and none of the companies state how long they will retain user data.  The United States has traditionally been more relaxed on privacy.  Nevertheless, in Katz v. United States, the Supreme Court established that individuals are entitled to a reasonable expectation of privacy. 

Privacy Policies are Subject to Change - Most brands have clauses stated that the terms of the privacy policy are subject to change.  For instance, Garmin’s privacy policy states “We will provide notice to you if these changes are material and, where required by applicable law, we will obtain your consent.”  Therefore, users do not have the ability to effectively control how their fitness data is used and shared.  In the past, Fitbit has shared users data in aggregate and de-identified.  For instance, in 2015, Fitbit used fitness information to measure and track its users’ excitement throughout the Super Bowl by examining users’ heart rates and distributed this information.  While aggregated and de-identified, some analysts have been able to re-identify the supposedly anonymous data.

FDA will not regulate fitness trackers – The FDA will not regulate products intended for general wellness, such as tools for weight management, physical fitness, or mental acuity.  While the FDA will not regulate fitness trackers in that arena, they will regulate medical devices, i.e. technology that makes a medical claim to treat or diagnose a disease or condition.  The FDA made this decision to strike a balance between unnecessary government red tape for applications trying to promote healthful activities and protection of private health information.  General wellness tools will still have to pass the Medical Electronic Data Technology Enhancement for Consumer’s Health Act (“MEDTECH”).  In contrast, HIPAA regulates Private Health Information (“PHI”).  HIPAA, as amended by the Health Information Technology for Economic and Clinical Health Act (“HITECH Act”), protects against the improper disclosure of private health information.

Tell Me More!

Additional Sources – If you find this topic interesting, here are a few fun reads for more information!

1.      Smart Watches and Weak Privacy Rules, N.Y. TIMES (Sept. 15, 2014), http://www.nytimes.com/2014/09/16/opinion/smartwatches-and-weak-privacy-rules.html?_r=0

2.      James A. Martin, Pros and Cons of Using Fitness Trackers for Employee Wellness, CIO (Mar. 24, 2014), http://www.cio.com/article/2377723/it-strategy/pros-and-cons-of-using-fitness-trackers-for-employee-wellness.html  

3.      Sophie Charara, If You Own a Fitness Tracker, Chances Are It’s a Fitbit, WAREABLE (May 22, 2015), http://www.wareable.com/fitbit/fitness-tracker-sales-2015-fitbit-1169

4.      Joseph Bradley, When IoE Gets Personal: The Quantified Self Movement!, CISCO BLOG (Sept. 10, 2013), http://blogs.cisco.com/zzfeatured/when-ioe-gets-personal-the-quantified-self-movement/

5.      Al Sacco, Fitness Trackers Are Changing Online Privacy--and It’s Time to Pay Attention, TECH HIVE (Aug. 15, 2014), http://www.techhive.com/article/2465820/fitness-trackers-are-changing-online-privacy-and-its-time-to-pay-attention.html  

6.      Stuart Dredge, Why the Workplace of 2016 Could Echo Orwell’s 1984, THE GUARDIAN (Aug. 22, 2015), http://www.theguardian.com/technology/2015/aug/23/data-and-tracking-devices-in-the-workplace-amazon  

7.      Jack Smith IV, Fitbit Is Now Officially Profiting From Users’ Health Data, OBSERVER (Apr. 18, 2014), http://observer.com/2014/04/fitbit-is-now-officially-profiting-from-users-health-data/#ixzz2zdt0LO2w  

8.      Emma Hutchings, Fitbit Users’ Sexual Activity Found In Google Search Results, PSFK (July 4, 2011), http://www.psfk.com/2011/07/fitbit-users-sexual-activity-found-in-google-search-results.html

9.      Kate Crawford, When Fitbit Data Is the Expert Witness, THE ATLANTIC (Nov. 19, 2014), http://www.theatlantic.com/technology/archive/2014/11/when-fitbit-is-the-expert-witness/382936/

10.  Should Companies Profit by Selling Customers’ Data?, The Wall Street Journal, https://www.wsj.com/articles/SB10001424052702304410204579143981978505724

11.  WHY SHOULD WE CARE WHAT FITBIT SHARES?: A PROPOSED STATUTORY SOLUTION TO PROTECT SENSITIVE PERSONAL FITNESS INFORMATION by Michelle M. Christovich published in Winter 2016. 38 Hastings Comm. & Ent L.J. 91

12.  YOU SHOULD BE FREE TO TALK THE TALK AND WALK THE WALK: APPLYING RILEY V. CALIFORNIA TO SMART ACTIVITY TRACKERS, by Katharine Saphner published in April 2016. 100 Minn. L. Rev. 1689

Leveraging Equity Incentive Structures for Third-Party Relationships: A Warrant-ed Alternative Security Structure for Angels and Advisors?

By: Jennifer Kay

April 2017

Startup founders are typically willing to offer straight equity, in the form of preferred or common stock, to angel investors and advisers who agree to commit their capital or time to the venture. That said, founders often feel that they must offer a significant proportion of equity to early-stage contributors who may or may not be committed to actively contributing to the company’s long-term success. To incentivize early-stage contributors’ long-term commitment to their company’s growth, founders should consider offering stock purchase warrants, instead of or in addition to straight equity, to angels and advisers. That said, founders should beware that issuing warrants may complicate their accounting and flexibility in later financing rounds.

Not to be confused with search warrants, stock purchase warrants are financial instruments that provide holders with the contractual right to buy a certain number of a company’s equity shares directly from the company a fixed price during a defined time period. Accordingly, warrants are similar to employee stock options, as both provide the contractual right to later purchase an equity security. That said, employee stock options are only available to intra-company parties (i.e., the company’s officers), while warrants are available to parties external to a company (i.e., angel investors or advisers deemed to be independent contractors of the company). Additionally, while companies that issue employee stock options typically do so under universal terms for all employees, companies that issue warrants typically do so in the context of third-party transactions (i.e., in exchange for an investment) and the terms of warrant contracts are typically negotiated deal-by-deal.

As startup founders consider various financing structures for their venture, they should consider incorporating warrants into the toolbox of financial instruments that they use as consideration for angel investors or advisers. Specifically, founders should consider offering warrants to angels or advisers in order to incentivize early investment as the exercise price of early-stage warrants would likely be significantly lower than later share value. In this scenario, if the stock value goes at least as high as a warrant’s exercise price before the expiry date, the warrant is “in the money” and the warrant-holder may purchase commensurate shares. Thereafter, if the future stock value exceeds the warrant’s exercise price, the warrant-holder may want to purchase the stock and then immediately resell the shares at a profit or hold the equity until a later acquisition.

Founders should also consider issuing warrants as a means of compensating external parties like angels or advisers for bringing in new business to the company (i.e., by setting performance-based milestones as the trigger for warrant exercisability). That said, warrants received as compensation for performing services will be taxed just like compensatory employee stock options (see http://www.thetaxadviser.com/issues/2014/sep/tax-clinic-10.html http://www.thetaxadviser.com/issues/2014/sep/tax-clinic-10.html).

Further, if a startup wants to avoid having to register their securities with the SEC, the startup will have to ensure that warrants granted as compensation for advisors meet the requirements of SEC Rule 701, thus further complicating warrant-based consideration structures (see https://www.pillsburylaw.com/images/content/4/8/v2/483/RobbinsRule7012013.pdf: Adopted under Section 3(b) of the Securities Act of 1933, Rule 701 provides an exemption from the registration requirements of the Securities Act for certain offers and sales of securities made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation by an issuer that is not subject to the reporting requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934 and is not an investment company registered or required to be registered under the Investment Company Act of 1940.)

In addition to the tax and securities law-related complications associated with warrants, the lack of shareholder voting rights associated with warrants may prompt angels or advisers to resist warrant-oriented consideration for their capital or time.

Accordingly, founders should understand, and weigh the benefits and drawbacks of, warrants as they structure angel and adviser equity grants. While warrants may provide a way to incentivize angels’ and advisers’ long-term commitment to a company, warrants may also provide accounting, tax, and securities law complications for both companies and warrant-recipients.

Sources

http://www.investopedia.com/articles/04/021704.asp#ixzz4dbn3vIdh   

http://www.startuplawblog.com/2009/12/16/what-is-the-difference-between-warrants-and-options/  

https://www.forbes.com/sites/mariannehudson/2016/12/22/what-the-heck-are-warrants-answers-to-questions-some-angels-are-afraid-to-ask/#5f07f90247e5  

http://www.vcdeallawyer.com/2009/08/30/lets-talk-angel-investors/    

https://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_BEST_PRACTICES_Deal_Structuring.pdf

https://seraf-investor.com/compass/article/stock-warrants-sweetening-deal-angel-investors  

http://www.investopedia.com/ask/answers/08/stock-option-warrant.asp  

http://www.investopedia.com/articles/04/021704.asp  

http://www.startuplawblog.com/2009/12/16/what-is-the-difference-between-warrants-and-options/  

https://www.allbusiness.com/warrants-what-they-are-and-how-to-use-them-15137265-1.html

Money, Money, Money: Traditional Financing or a New Wave of Crowdfunding?

By: Samantha Gross

April 2017

Steve Jobs once said, “I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance.”  Perhaps in avoidance of sounding cynical, Mr. Jobs does not address the other half of the equation – money.  The reality is that entrepreneurs need initial financing to get a business up and running.  In fact, about 80% of startups fail, mainly due to lack of capital.  With more and more startups vying to enter the market, investors are setting higher benchmarks to protect their money.  The result: great difficulty for first-time entrepreneurs without substantial personal resources and connections. 

Traditional paths for financing have included investments from personal savings, friends and family, the elusive angels, and the sophisticated venture capitalists.  In recent years, four different types of crowdfunding have paved a new path for raising seed capital.  Financial analysts all agree that the type of financing an entrepreneur accepts is extremely important and involves much thought; however, the best type of capital-raising method is still contested.  This blog post evaluates the benefits and risks of so-called “smart money” and “dumb money” for an average entrepreneur starting with absolutely no leads for financing.

“Smart Money”: The Value of Human Capital

            “Smart money” typically refers to investments from those, who are experienced, well-informed, and well-connected – popularly known as angel investors and venture capitalists.  Such investors often take active roles in their portfolio companies, as advisors, board members, or endorsers, which can open different doors for entrepreneurs.  In other words, “smart money” provides both financial and human capital.

Established business owners, experienced investors, and financial advisors all express the importance of finding the right fit, when entering into a financing deal.  There must be a covenant of honesty, trust, and transparency because the relationship between a seed investor and entrepreneur can last up to six or seven years.  Thus, a great benefit to obtaining money from friends and family, angel investors, and even venture capitalists is the support provided by the person backing an entrepreneur’s sweat and labor.  Nevertheless, such options are not always readily available, especially since the competition among startups is currently hot and heavy.  As a result, a new path for funding has emerged, referred to as crowdfunding.          

What Type of Crowdfunding?

            It is important for an entrepreneur to recognize that there are four different types of crowdfunding, and carefully understand the process of each before proceeding full speed ahead.

1.      Donation Based Crowdfunding

            In donation based crowdfunding, the contributing person gives money or other resources to the entrepreneur without anything in return, simply because they support the idea.  This type of crowdfunding has proven successful for social causes and charity organizations.  However, this option is not necessarily sustainable for a business, which needs a larger amount of capital at the initial stage.   

2.      Rewards Based Crowdfunding

            In rewards based crowdfunding, the contributing person gives money to the entrepreneur in exchange for a reward, typically some good or service.  A famous example of rewards based crowdfunding was Zach Braff’s campaign to raise money for his film “Wish You Were Here.”  He raised $3.1 million on Kickstarter, and gave his backers access to the film’s production in exchange.

3.      Equity Based Crowdfunding from Accredited Investors

            Entrepreneurs can raise money and issue shares over the internet from accredited investors, individuals who either have a net worth over $1 million (excluding a primary residence) or an income of at least $200,000 for the preceding two years.  However, entrepreneurs, who have yet to establish connections within the investor world, may face the same difficulty in raising funds from accredited investor crowdfunding as they would from angel investors or venture capitalists.

4.      Equity Based Crowdfunding from Unaccredited Investors

            On May 16, 2016, Title III of the JOBS (Jumpstart Our Business Startups) Act came into effect, making it possible for entrepreneurs to raise money in exchange for equity from the general public, not just accredited investors.  The idea behind the act was to allow more startups, which do not necessarily fit into the angel or venture capitalist model, to receive funding from a larger pool of investors.  Whether this relatively new option is actually beneficial and useful for entrepreneurs is still uncertain.

Benefits of Crowdfunding

            In 2015–2016, donation and reward crowdfunding raised a total of $5.5 billion, while equity crowdfunding under-performed in comparison, only raising a total of $2.5 billion.  The bottom line is that entrepreneurs, who may not be eligible among angel investors and venture capitalists, can access funds relatively quickly through crowdfunding.  Reaching a diverse investor pool from around the globe is an attractive advantage.

Disadvantages of Crowdfunding

            In contrast to the “smart money” of angel investors and venture capitalists, financial experts sometimes refer to equity based crowdfunding as “dumb money” – mainly because such financing does not provide the added expertise of a well-seasoned investor committed to advising his portfolio clients.  Rather, the relationship is reduced to an online portal of many investors, willing to make small investments in all sorts of businesses.

            Another major disadvantage is the rather heavy regulatory scheme.  For instance, the maximum offering amount is $1 million in a twelve-month period, the investors are subject to limits with regard to the amount of capital they can contribute in a twelve-month period, the companies are subject to disclosure requirements as well as restrictions in advertising, and the crowdfunding must be conducted through a registered portal.  It remains to be seen whether all this red tape is worth it or even feasible for an entrepreneur lacking in resources.

Debt Funding May be a Lifesaver

            While financial analysts are not convinced about the benefits of equity based crowdfunding from non-accredited investors, there may be some great potential from Title III debt crowdfunding.  For small businesses with cash-flow, debt crowdfunding works well because payments do not usually start immediately and are based on a percent of revenue; as a result, businesses are not burdened with fixed loan payments.  Ultimately, debt crowdfunding can be cheaper and faster than going to a bank with the added benefit of marketing exposure through a crowdfunding portal. 

            Financing options are distinct and numerous; nevertheless, it is up to the entrepreneur to find the best means for a happy start-up ending.

Are Your Mobile Application or Website Terms of Use/Privacy Policies Legally Enforceable?

By: Joseph P. Glackin

April 2017

In this day in age, more and more businesses are utilizing websites and mobile applications as their point of contact with their target audience/consumers. This post will analyze some of the agreement types in which privacy policies and terms of use agreements are conveyed within the aforementioned mediums. In doing so, it will analyze the enforceability of these agreement types, and make a final recommendation on how businesses should protect the enforceability of their agreements with their users. However, before discussing the agreement types, it is important to first understand some of the underlying contract principles.

Fundamental Contract Principles

            An essential element under basic contract formation principles is a mutual manifestation of assent. Manifestation of assent describes words or acts that objectively show that there has been consent to a contract between parties. Where assent to terms is passive, the question of contract formation turns on weather a reasonable person would be on notice of the terms at issue. If a reasonable person was on notice but did not read the terms, a contract would still be enforceable.

Browswrap v. Clickwrap Agreements

A recent 2015 decision out of New York in Berkson v. Gogo LLC provided a comprehensive review of the law to date on both browsewrap and clickwrap agreements. In summary, browsewrap agreements are agreements in which a user accepts a website’s terms of use by browsing a site or using an application. Clickwrap agreements are agreements in which a user accepts a website’s terms of use by clicking an “I Agree” or “I Accept” button, with a link to the agreement being readily available. This case also helped establish a set of general principles for internet and mobile application contracts.

These principles being:

1)              Terms will generally NOT be enforced if (a) no evidence that the website user had notice of the agreement; or (b) a hyperlink to the terms is buried at the bottom of a webpage.

2)              Terms will be enforced if design or content of a website or application encourages the user to review the terms.

Browsewrap Agreements

Browsewrap agreements refer to a contract or agreement covering access to use of materials on a website or downloadable product such as a smartphone application. In most cases, websites typically have a hyperlink to their terms and conditions, and notify consumers/users that by simply using the website, running an application, or accessing information, a user is agreeing to be bound to the aforementioned terms.

If a user is agreeing to be bound to certain terms simply by using a website or an application, there is no manifestation of assent. In practice, this means that a user can continue to use an application or website without actually visiting the webpage of terms or even knowing that the terms are of existence. This is counterintuitive to a reasonable person having notice of the terms, and thus is hard to be held as an enforceable contract. Taking this into consideration, courts have generally come to a consensus that browsewrap agreements are generally only enforceable if users have both a reasonable notice of the terms and have assented to those terms.

Reasonable Notice of Terms

In the 2014 decision of Nguyen v. Barnes & Noble Inc. the court stated that the “validity of a browsewrap agreement turns on whether the website puts a reasonably prudent user on inquiry notice of the terms of the contract.” Courts tend to look at the design and content of a website or application and the agreement’s webpage in finding whether a reasonably prudent person would be on inquiry notice of the terms. In addition to the inquiry notice requirement, in Small Justice LLC v. Xcentric Venures LLC, a Massachusetts Court looked at the “conspicuousness and placement” of a link to the terms and conditions, and took “other notices given to users of the terms of use, and the website’s general design” into consideration to determine whether a reasonably prudent person had inquiry notice of the terms.

Assent to the Terms

In order for a court to infer assent and hold a browsewrap agreement as enforceable, an individual user or consumer may impliedly accept terms by their conduct (such as accessing the site or service), and purchasing a product or service from the website or application. Recent trends have pointed out that courts are more likely to enforce browsewraps against corporations and businesses, and are less likely to enforce against individual consumers.

Clickwrap Agreements

Unlike browsewrap agreements, clickwrap agreements require an active role by individual users, where a user has to click a box stating “I AGREE” after being presented with terms of agreement, but prior to downloading or making a purchase. This affirmative action of clicking “I AGREE” manifests assent. In most cases, courts have enforced clickwrap agreements. However, more recently courts have expanded the inquiry to look at whether the terms were reasonably communicated to the user (i.e. effectively fulfilling the aforementioned reasonable notice requirement). It has been noted that the box that a user has to click needs to be clear and concise, and that checking it constitutes assent to the terms. Simply displaying a “Download” or “Proceed” button is not sufficient. The court in Specht v. Netscape Communications Corporation, in the 2nd Circuit, stated “a consumer’s clicking on a download button does not communicate assent to contractual terms if the offer did not make clear to the consumer that clicking on the download button would signify assent to the terms.”

Scrollwrap Agreements

Scrollwrap agreements are clickwrap agreements with an added attribute. This attribute being that a user is presented with the entire agreement or terms of use and must physically scroll to the bottom to find the “I Agree” or “I Accept” button. This adds another layer of protection in making sure a user has reasonable notice of the terms, and thus makes the contract that much more enforceable. With this being said, courts tend to favor enforceability with scrollwraps, as notice is clear and assent is satisfied via clicking a certain box.

Recommendations and Best Practices

A. The Scrollwrap Agreement

            After much research, it is recommended that a company utilizing a mobile application should heavily side with cautionary measures. These cautionary measures are sufficiently fulfilled with the use of a scrollwrap agreement. As previously mentioned, in this approach a user has to confront an agreement, scroll down to the bottom of the aforementioned agreement, check a box agreeing to be bound, and click a button confirming assent to the contract.

B. “YES” Button in Response to Asking if User Agrees to be Bound

Another viable approach is being more user friendly, but is just as valid in proving explicit assent. In this approach users would be asked to click on a button marked “YES” in response to a statement asking if the user agrees to be bound by a unilateral contract such as “Terms of Use” and the agreement is presented to the user above the button in the form of a hyperlink.

For added protection, it would be recommended to mandate that a user, in some way or process, be unable to click yes unless they have successfully navigated to the hyperlink taking them to the terms of use page. However, this may frustrate users as it requires them to actually navigate to the hyperlink.

Scaling Startups without Sacrificing CEO Sway: Should Founders Consider Adopting Snap Inc.’s No-Vote Stock Structure?

By: Jennifer Kay

March 2017

Snap Inc.’s February 2017 S-1 Registration Statement with the U.S. Securities and Exchange Commission reveals that the tech giant behind Snapchat intends to issue no-vote shares in its Initial Public Offering. With the advent of no-vote shares, start-up founders may be enticed to offer company equity to investors that would provide capital gain and dividend benefits without granting any voting rights to such shareholders. Although Snap’s no-vote share model is theoretically advantageous for company founders seeking to retain control over their brainchild, Snap’s unprecedented, unorthodox stock structure is unlikely to gain traction in the startup community, as most companies lack Snap’s level of bargaining power to convince potential investors to buy shares without voting rights.

While SEC and stock exchange rules permit issuers to sell no-vote shares as a means of allowing founders to retain control of their company, such stock is rarely issued and typically only issued after an IPO, as one company’s no-vote shares would theoretically be less valuable than their competitors’ single-vote shares. Still, the potential of the no-vote share model will be tested by the success of the shares’ sales in Snap’s IPO and Snap’s audacious proposal is presumably only possible because of its wildly-popular mobile app, Snapchat; the extraordinary, multi-billion dollar valuations of Snap in past financing rounds and as offered by rejected acquirers like Mark Zuckerburg; widespread public interest in the mobile app market; and the company’s seemingly-unbounded growth. These factors have contributed to the founders’ demonstrated belief that they will still be able to garner record-setting IPO stock sales without offering voting rights with company shares.

As articulated in the company’s February 2017 S-1, Snap will have three classes of common stock: Class A common stock, Class B common stock, and Class C common stock. Class A common stock will not be entitled to any votes, while Class B common stock will be entitled to one vote per share and Class C common stock will be entitled to ten votes per share. The S-1 further indicates that the only stock being offered in the IPO is Class A common stock with no voting rights and that “shares of Class B common stock or Class C common stock sold by existing stockholders will lose voting rights when such shares convert into Class A common stock or Class B common stock as such shares are sold.”

The S-1 indicates that Snap co-founders, Evan Spiegel and Robert Murphy, hold Class C common stock entitling them to 10 votes per share, but the publicly available version of the S-1 does not specify the number of Class C shares that each founder owns. Still, the S-1 explicitly acknowledges that “Mr. Spiegel and Mr. Murphy, and potentially either one of them alone, have the ability to control the outcome of all matters submitted to our stockholders for approval, including the election, removal, and replacement of directors and any merger, consolidation, or sale of all or substantially all of our assets. If Mr. Spiegel’s or Mr. Murphy’s employment with us is terminated, they will continue to have the ability to exercise the same significant voting power and potentially control the outcome of all matters submitted to our stockholders for approval.”

Accordingly, start-up founders may seek to mimic the no-vote share model to preserve company control and safeguard the company from activist investors or unfriendly takeovers. That said, start-up founders should understand that they would need to have colossal bargaining power in order to garner investor demand for no-vote, or even limited vote, shares. Still, start-up founders interested in retaining control should consider trends in IPO financing models like the Snap no-vote structure to ensure that their early-stage financing agreements allow for creative equity structures that would minimize founder decision-making dilution at later stages.

https://www.sec.gov/Archives/edgar/data/1564408/000119312517029199/d270216ds1.htm

http://www.investopedia.com/articles/fundamental/04/092204.asp

https://www.forbes.com/sites/investor/2014/07/16/not-all-shares-are-created-equal-more-multiclass-stocks-to-join-google-in-the-sp-500/#150d416850cc

https://www.law360.com/articles/886185/snap-s-expected-no-vote-shares-likely-to-remain-an-outlier

http://fortune.com/2016/05/07/facebook-stock-mark-zuckerberg-sec/

http://www.investopedia.com/terms/v/votingright.asp

https://www.crunchbase.com/organization/snapchat/funding-rounds

https://www.crunchbase.com/organization/snapchat#/entity

https://www.snap.com/en-US/news/post/recent-additions-to-team-snapchat/

https://www.forbes.com/sites/jeffbercovici/2013/11/13/facebook-wouldve-bought-snapchat-for-3-billion-in-cash-heres-why/#6c1d36d543de

https://www.quora.com/How-did-Snapchat-get-traction

Efforts to Ease the Regulatory Burdens And Increase Growth Among Small Businesses and Start-Ups

By: Michael Thomas

March 2017

Starting a new business or running a small one comes with a number of hurdles that a business owner must overcome. An entrepreneur trying to get a business off the ground must have a new product, idea, or service that adds some value; find funding to support the development of the idea or product, and eventually get it to the relevant market. Similarly, a small business must continue to find ways to grow and stay competitive in a marketplace that usually includes much larger companies with extensive resources. In addition to these concerns, studies indicate that the regulatory burden plays an important role in the development and growth of small businesses.

 Data collected by the U.S. Department of Labor shows the number of businesses less than one year old increased steadily from 1994, where the number was roughly 570,000, up until 2006 when that number reached a high of 715,734. Following 2006 this number decreased rapidly, and as a result of the recession hit a low in 2010, dropping by almost 25%. Since 2010 that number has been on the rise and in 2015 the number of businesses less than one year old was 679,072, a number approaching the high point reached in 2006. The study also shows that jobs created by businesses less than one year old are trending along the same lines but with a slower rate of increase. In 1999 the number of jobs created by businesses less than one year old reached a high of 4,736,499. As a result of the recession, this number was cut almost in half to roughly 2,500,000. Following the recession new jobs created by businesses less than one year old have increased by a rate of roughly 15,000 jobs/year but this number is nowhere near the level seen in 1999. However, the data is certainly encouraging as the number of businesses/year and jobs/year are clearly on the rise. The question still remains, could these numbers be better?

Regulations matter to businesses of all sizes but they particularly affect small businesses and start-ups. Many small businesses and start-ups lack the resources to devote a special department or person to compliance work. In most cases the founder acts as the compliance, finance, sales, supply chain, and development person. This makes the cost/person of dealing with regulations higher for smaller businesses. Small business owners indicated tax, healthcare, and overtime regulations as the most burdensome. The U.S. Small Business Administration does provide some helpful guidance in this area but if the owner cannot handle this work on their own, they must spend the money and hire someone to help.

Regardless of the industry or business a start-up enters, there are undoubtedly a number of laws and regulations that need to be complied with. This is in addition to any licenses and permits that need to be acquired. For a new or small business, ensuring compliance with these regulations is time consuming as well as costly. Sorting through the often difficult to read regulations takes time. A study by the National Small Business Association (“NSBA”) reports that roughly 44% of small businesses spend at least 40 hours a year ensuring they are in compliance with tax, healthcare, and employment regulations. While this may not seem like a large number it is worth considering that many people starting new business or running their own small business hold another job. When taking into account everything else that needs to be done to get a new business up and running, 40 hours a year can be a substantial amount of time devoted to understanding regulations. In addition to the actual time spent on regulations, the yearly costs small businesses spend on compliance are roughly $12,000. One of the more surprising values from the study by the NSBA was the estimated average regulatory start-up costs incurred by small business owners, $83,000. Given 55% of all businesses have gross revenues under $1,000,000 in their first year, the study highlights the considerable time and cost spent on understanding regulations and compliance by those starting and operating new businesses.

            Many small businesses indicate that regulations at the federal level cause the highest burden. In an effort to ease some of the burden, two executive orders have been signed this year by President Trump. The first was signed on January 30th, 2017 with small business owners surrounding the President and is meant to reduce regulation and control regulatory costs for private businesses. The second, signed four days later on February 3, 2017, is targeted at easing the restrictions on financial institutions. It is important to keep in mind that while these executive orders do not create new laws (very limited exceptions apply), they do set policy directives that Congress and federal agencies must follow.

            The order reducing regulations and regulatory costs has some key components listed in the directive. The order’s primary method of reducing regulations is laid out in Section 1; it states “that for every one new regulation issued, at least two prior regulations be identified for elimination.” The order also carries provisions which cap the net increase in regulatory costs at zero “unless otherwise required by law” and setting a budget for fiscal year 2018 and beyond. There are certain exceptions listed in Section 4 of the order such as regulations pertaining to national security, the military, and agency organization. While it is unlikely the order will produce any significant changes, it will hopefully result in the purging any outdated or ineffective regulations. This matters to start-ups and small businesses because it eliminates unnecessary reading and time spent understanding complexly written rules that do not apply. This can save time and money for small businesses and start-ups, allowing them to allocate it elsewhere such as revenue and job growth.

            The executive order signed February 3, 2017 seeks to “foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis.” This goal of this order is to ease restrictions on financial and lending institutions. This matters to small business owners because when the Dodd-Frank Act was passed it had the effect of severely slowing down lending by banks. This made it very difficult for small businesses and start-ups to get loans. Although the executive order imposes broad principles, it has the ultimate goal of easing regulations for financial institutions that in turn could increase the availability of capital to small businesses and start-ups.

            There are many factors that go into ensuring start-ups and small businesses continue to grow and provide jobs. Reducing the regulatory burden is simply one piece to the puzzle and will hopefully help encourage those with a good idea to start their own business and keep existing small businesses running. In addition to the actual reduction of regulations, things such as making regulations easier to understand and reducing penalties for first time offenders acting in good faith would help alleviate costs and concerns. It remains to be seen how these executive orders will play out or how long it will take for them to have an effect, but hopefully their goals are realized through continued growth for the start-ups and small businesses.