Hey, Could You Tag Me in That? Navigating Instagram for Your Business

By: Wallis Linker

March 2018

In 2012, the social media powerhouse Facebook purchased the marginally smaller social media app Instagram for $1 billion.  Instagram began as a simple photo sharing app for friends to show their pictures to one another.  It has since grown into an online community of photo sharing focusing on personal photos, creative art, niche categories (like ‘food porn’ or memes), and professional accounts. With Instagram’s nearly constant app updates (like adding “stories” to emulate rival Snapchat) it comes as no surprise that it is one of the most popular social media platforms worldwide.  As of September 2017, Instagram reported 800 million monthly active accounts.

Instagram is a convenient way for a company to engage with a huge audience.  For example, Nike  (@nike) has 76 million followers, Kylie Cosmetics (@kyliecosmetics), of Kardashian infamy, has 15.5 million followers, and Chipotle (@chipotlemexicangrill) has 533 thousand.  Instagram also has features such as “explore” and “suggested for you” that push an account’s photos onto the feeds of users who are not current followers.  Instagram also has a feature where a user can look at every picture that was tagged at a certain location via ‘Geotagging.’  Even the ability to search hashtags allows a business to reach interested consumers.  It is seemingly effortless to gain exposure through the app’s coding.

INSTAGRAM BASICS

The basic features of Instagram can improve the business presence of both startups and more established companies.  For instance, Charity Water (@charitywater) is a non-profit that works to bring clean water to remote areas throughout the world, primarily in Africa.  The Charity Water Instagram feed showcases crisp, focused photos highlighting clear water and provides summaries of success stories.  Sharp, high definition photos reinforce the idea of cleanliness and drinkable water.  Charity Water encourages its followers to contribute to the charity, through captions that tell individual stories, pulling at heartstrings, and which make available a link to their website.  Similarly, clothing store Madewell (@madewell) has also achieved a strong brand aesthetic simply through their posted photos. Madewell gives off the sense of simple, yet trendy fashion choices for women.  Its Instagram page shows this; photos of somewhat monochromatic outfits against a solid color background with the occasional nod to hipster trends (i.e. handwoven bowls, record players, succulents) populate its page. 

INSTAGRAM BUSINESS TOOLS

Instagram, recognizing the demand for businesses to market and build a brand through its app, has added features facilitating its use by startups and entrepreneurs.  In 2016, Instagram rolled out ‘Instagram Business Tools’ which are free to any business with a Facebook page.  The most useful of the new tools is the ability to create a ‘Business Profile’ allowing a business to sync calls, texts, emails, and geographic locations through the app for all viewers.  This profile option also gives the account owner access to “Insights.”  Insights give business accounts information about who their followers are and which posts have the most views and “likes.”  In utilizing Instagram’s “Business Tools,” businesses get a better sense of their viewer base and how to target their ideal consumer.  Lastly, the profile allows a business to “promote,” letting the user turn a well-performing post into an ad within the app itself.  The user can pick the audience to push the ad to or choose to have the app suggest targeting based on Instagram’s algorithm.  This is a fantastic tool for a business with a tight advertising budget to only push already well-performing images as ads.

Outside of the parameters built into the app for businesses, many businesses choose to build a following and advertise through “influencers.”  Influencer marketing, an ever-growing marketing tactic, is when a business pays or sends free goods to an individual who has a strong presence within a demographic, and whose public use or support of a product or group would result in third parties using or supporting that same product or group.  A popular mechanism, especially amongst companies targeting Millennials or GenZ, influencer marketing can offer considerable rewards at little cost.  This potential has been realized by many in the business world; in January 2018, Forbes created a checklist for companies interested in influencer marketing on Instagram and how to best plan for the desired results. 

FEDERAL GUIDELINES FOR BUSINESS USE OF INSTAGRAM

However, boosting a brand via Instagram has limitations.  The Federal Trade Commission, a government agency that regulates trade and commerce within the United States, has protocol regarding marketing.  Relevant to Instagram advertising is Section 5(a) of the Federal Trade Commission Act (15 USC §45) which prohibits “unfair or deceptive acts or practices in or affecting commerce.”  The FTC defines deceptive practices as an act or practice where:

(i)         a representation, omission, or practice misleads or is likely to mislead a consumer;

(ii)         a consumer’s interpretation of the representation, omission, or practice is considered reasonable under the circumstances; and

(iii)         the misleading representation, omission, or practice is material

In can be unclear to a business what “unfair” or “deceptive” means in regard to its social media presence.  In letters sent to Instagram users the FTC found violating this Act, the FTC noted:

if there is a ‘material connection’ between an endorser and the marketer of a product – in other words, a connection that might affect the weight or credibility that consumers give the endorsement – that connection should be clearly and conspicuously disclosed, unless the connection is already clear from the context of the communication containing the endorsement. Material connections could consist of a business or family relationship, monetary payment, or the provision of free products to the endorser. 

The letters outlined common mistakes and recommendations on how to make a paid partnership more apparent to the average user:

Consumers should be able to notice the disclosure easily, and not have to look for it. For example, consumers viewing posts in their Instagram streams on mobile devices typically see only the first three lines of a longer post unless they click “more,” and many consumers may not click “more.” Therefore, you should disclose any material connection above the “more” button. In addition, where there are multiple tags, hashtags, or links, readers may just skip over them, especially where they appear at the end of a long post.

The hashtags referenced are the common usages of “#sp,” “#Thanks [Brand]” or “#partner.”

Thankfully, in June 2017, Instagram revealed a new feature that should make it easier for businesses unsure of FTC guidelines to continue promoting itself through partnerships.  Instagram has added a “paid partnership with” sub-header on sponsored posts and stories in response to the FTC letters.  This sub-header makes the business relationship at play sufficiently clear to a user.  The update also gives Instagram the ability to easily track the performance of sponsored content and adapt the app to better suit its users, including the businesses engaged in promotional posts.

Instagram is a tool well suited for businesses; it can be used for advertising, promotion, and brand development.  As an entrepreneur, Instagram should be used by entrepreneurs to grow brand presence and recognition.  It is low cost and has the potential to allow a company to reach millions of people worldwide.  But all good things come at a price; businesses must ensure they follow the FTC guidelines against unfair or deceptive posts in all paid partnerships and endorsements.

TRADEMARK TROLLS: A WARNING TO THE ENTREPRENEUR

By: Gabriella Falcone

March 2018

Creating a name for a startup company is a daunting task for entrepreneurs.  With such a decision comes countless hours of research, efforts to incorporate the business entity, and securing intellectual property rights to ensure that others will not use the same name.  For the entrepreneur, trademark registration of a company name symbolizes a weight lifted from their shoulders, as it officially signals that the name is theirs.  What they do not realize, however, is that the name will not remain theirs if trademark trolls have the final say.

Trademark Trolls Explained

Unfortunately for startups, many large companies with deep pockets often engage in needless litigation to prevent anyone and everyone from using even remotely similar trademark names.  There are two common tactics utilized by trademark trolls to beware of.  The first tactic is more opportunistic and involves companies who register trademarks with no intent to actually use them.  Such companies use the trademark as leverage in keeping an eye out for companies using similar marks in an attempt to charge them licensing fees.  The second tactic, which is more concerning for startup companies, involves large companies who threaten to sue anyone using a similar mark for trademark infringement.  [1]

To anyone with a basic understanding of intellectual property law, the idea of trademark trolling is absurd, largely because in the eyes of the law, there is no merit to many claims that the simple use of a word in a completely unrelated market infringes the rights of another holder of rights in that word.  The right to sue for trademark infringement exists to protect owners’ rights and to protect the public from unfair competition.   However, for startup companies, the threat of such frivolous litigation can be catastrophic.  Startups often do not have the funds or legal resources necessary to combat the litigation, and are forced to allow the large company trademark trolls to bully them into cessation of using the name.

USPTO Study

In a recent study, the United States Patent and Trademark Office’s Report to Congress on Trademark Litigation Tactics defined a trademark troll or bully as a trademark owner who uses its rights to harass or intimidate other businesses beyond the scope of what the law is reasonably interpreted to permit. [2]  In this study, the USPTO acknowledged from data gathered by attorneys, professors, and businesses of all sizes that aggressive litigation and pre-litigation tactics by trademark bullies are often targeted at small businesses. [3]  Such aggressive tactics include threatening cease and desist letters alleging that use of a name infringes the accuser’s trademark, as well as the filing of lawsuits.  In many instances, these tactics scare the smaller businesses away from continuing to use the name in fear of retaliation by the larger trademark owner.  This fear largely stems from the lack of resources available to fight back against the accusing party.

The Problem with Proving Infringement

From the perspective of a lawyer who can comprehend what is necessary to establish and fight a trademark infringement case, trademark trolls do not pose a major legal threat simply because their allegations often do not hold much strength.  Under the Lanham Act, in order to prove trademark infringement, a trademark holder must show (1) that they have a valid trademark; (2) that someone else used their mark in commerce; and (3) that such use is likely to cause confusion to consumers as to the source of the goods or services of the mark. [4] Factors relevant to whether a trademark is likely to cause confusion include the strength of the mark being infringed, how similar the two marks are, evidence of confusion, etc.[5]  The element of confusion is where trademark trolls will often fall short.  Many trademark trolls sue or threaten to sue anyone who simply uses a singular word present in their trademarks.  In instances where they sue companies completely outside of their relevant industry or market, it seems highly unlikely that confusion could be possible.

To illustrate this problem, many point to companies like Monster Beverage as a classic example of a trademark troll.  Monster has filed more trademark infringement suits than most companies in the United States. They take their tactics to the extreme of suing anyone who attempts to use the word Monster.  For example, Monster recently sued MonsterFishKeepers, an online forum that allows users to discuss fish.  A rational person would likely never confuse an aquarium-oriented online forum with a corporate giant known for its energy drinks just because the two happen to have the word “Monster” in their names.  Nevertheless, Monster Beverage persisted with aggressive cease and desist letters and threatened litigation to make them stop using Monster in their name. [6]  Additionally, in January 2018 alone, Monster sued at least five companies for use of the word Monster in trademark applications.  Two of these applications include “Mini Monster” in the restaurant industry, and “Monster Equipment” in the auto industry.  [7]

In addition, Travelers Insurance is known for its bullying of companies who use umbrellas in their logos.  Though they belong to the property and casualty insurance market, Travelers has gone so far as to challenge the use of umbrellas in marks by software companies, as well as health and nutritional based companies.  It is highly unlikely that a consumer seeking to buy a nutritional supplement from a small company could potentially be confused into thinking they were buying said supplements from a large property insurance company solely because both companies have umbrellas in their logos. [8]

The Effect on Startup Companies

On the surface, receiving a cease and desist letter to stop use of a trademark because it could potentially infringe on someone else’s mark may not be concerning to most, especially if the infringement allegation has no merit.  Additionally, larger, deep-pocketed companies with access to legal resources can afford to fight back against such claims.  However, it is not the merit of the case that poses problems for entrepreneurs and startup companies; it is the cost involved in proving that such accusations are meritless.  The legal fees associated with doing so can start as high as hundreds of thousands of dollars depending on the profile and duration of a case.  The American Intellectual Property Law Association estimates that such litigation can cost a company up to $25 million to dispute. [9]  For a startup company just getting off the ground, legal fees this high are enough to put them out of business before the business even takes off. 

There is unfortunately no concrete answer as to how to ease the entrepreneurial concern of being retaliated against by a trademark troll.  With this in mind, the best advice to give to an entrepreneur starting a business is to trademark a name and logo that is as unique as possible, and try as hard as possible to ensure that nobody has ever used it before.  Obviously, this is easier said than done.

CREATIVITY IN COMPENSATION SCHEMES: DO ENTREPRENEURS’ COMMON STRATEGIES RUN AFOUL OF WAGE & HOUR LAWS?

By: Zachary Fountas

March 2018

The Hiring Problem

            A majority of small businesses fail within their first five years, and negative cash flows are common in the early stages of most startups. Preferred CFO notes a recent study by U.S. Bank which found that 82% of the time, the cause of small business failures is poor cash flow management. For the determined entrepreneur, the solution to this problem seems simple: recruit talented individuals to join the team and the business will start turning profits. The only issue: how do cash strapped businesses recruit top tier talent during the initial stages?

Stock Options and Their Legality

The entrepreneurial spirit and startup culture has developed creative compensation schemes to deal with limited cash flow. To combat the lack of funds, many startups choose alternative payment structures or employment arrangements such as offering stock options, contracting workers as independent contractors, or hiring trainee interns. There is no question that stock options can entice talented recruits to provide their services for below market value, especially if they believe in the company. Yet, startup culture has become comfortable pushing this scheme further, frequently offering stock options as compensation in lieu of any salary at all. Is it legal to offer stock in lieu of cash? The answer is generally no, with limited exceptions.

The Fair Labor Standards Act of 1938, codified in 29 U.S.C. Chapter 8, first created the right to a minimum wage in the United States. In 2018, only five (5) states have either set no minimum wage or have set a minimum wage below the federal level, and many states have increased their wage and hour law protections to exceed those of federal law. Massachusetts maintains a minimum wage of $11.00/hr for all employees which is to be paid in cash or check. According to the allowable payment forms, providing equity – regardless of whether the value of that equity meets or exceeds minimum wage – is insufficient to comply with the law.

            Given that it is clear that employees must be paid minimum wage in cash or check, why might entrepreneurs offer equity stakes in lieu of cash payment? First, many entrepreneurs erroneously believe that offering an employee equity converts his or her position into that of a business owner exempt from minimum wage laws. Second, entrepreneurs often think that the individuals receiving stock consideration do not qualify as employees under applicable law.

            The requirements for whether an individual is a business owner and exempt from minimum wage under the Fair Labor Standards Act is that they must be employed in a bona fide executive capacity, be engaged in managing the business, and hold a 20-percent equity interest in the company. In addition, the Act limits the maximum number of individuals (5) a business could theoretically exempt. Meeting these requirements is quite challenging for startups. Cognizant of running afoul of minimum wage laws, and unwilling to grant one-fifth (1/5) of the company’s equity to one individual, startups turn to an emerging alternative employment scheme: the independent contractor.

The Independent Contractor: Uber as a Case Study

            Independent contractors by definition are not employees, and as a result, employers are not subject to abiding by the same wage & hour regulations that govern employees. Therefore, successfully categorizing workers as independent contractors instead of employees could be the difference between failure or success for a business suffering a liquidity crisis. Over the past few years, the ridesharing app Uber has led the charge with respect to classifying workers as independent contractors. In 2015, Uber claimed to have 850 employees and 163,000 drivers, all designated as independent contractors.

            The budding gig-economy, spurred by the financial crisis of 2008, established a veritable Wild West of alternative employment arrangements. Uber seized the opportunity to designate drivers as “independent contractors” and realized massive success. This success has thrust Uber into the national spotlight which has subjected it to examining eyes. Uber has an uphill battle in the years to come as it defends against lawsuits in multiple states over its designation of drivers as independent contractors. The results – whatever they are – will have a profound impact nationwide. In Massachusetts, however, even a successful Uber defense to its classification may be of little help to the startup entrepreneur looking to avoid minimum wage laws. 

Massachusetts has a stringent independent contractor test that requires the worker to be:

1.      free from control and direction in connection with the performance of their services;

2.      performing a service that is outside the usual course of business of the employer; and

3.      customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

Uber may ultimately triumph in its claim that Uber drivers are free from the company’s control because they choose when, where, and to some degree, how to perform their services. It may also be able to succeed in its claim that it is a technology company, not a transportation company, and therefore drivers are outside the usual course of Uber’s business. Finally, it may prevail it claiming that driving, much like taxi-driving, is an independently established trade. If so, Uber drivers will be deemed independent contractors. It is unclear whether Uber will ultimately succeed, but even if it does, can most startups in the state – lacking the deep pockets of Uber – similarly succeed? Likely not. With few options left and a need for talent, many startups resort to hiring interns. 

Startup Interns: Another Employment Classification

A longstanding view of the Department of Labor is that individuals providing services for a company, who are not independent contractors, are “employees” unless those individuals satisfy statutory exemption or exclusion requirements. The trainee, or intern, exemption has a six-part test that must be met:

1.      The training, even though it includes actual operation of the facilities of the employer, is similar to that which would be given in a vocational school;

2.      The training is for the benefit of the trainees or students;

3.      The trainees or students do not displace regular employees, but work under close supervision;

4.      The employer that provides the training receives no immediate advantage from the activities of the trainees or students and, on occasion, his operations may even be impeded;

5.     The trainees or students are not necessarily entitled to a job at the conclusion of the training period; and

6.      The employer and the trainees or students understand that the trainees or students are not entitled to wages for the time spent in training.

            Though the Federal standards for trainee exemptions are lenient enough to be met, entrepreneurs in Massachusetts must also comply with state law. The Massachusetts Department of Labor Standards (DLS) determines whether an individual is an intern/trainee by the same test set forth above. However, according to a DLS opinion letter, “the Massachusetts Minimum Wage Law does not apply to trainees enrolled in training programs at charitable, educational or religious institutions.” It is unlikely that most for-profit startups will meet this definition. This reality, in conjunction with the prior independent-contractor test, strongly suggests that intern/trainees should be viewed as employees and paid minimum wage, particularly in Massachusetts.

            As a result, entrepreneurs must consider their employment schemes in conjunction with their overall business goals. If a member of the startup is integral to its success, granting the requisite equity for a business owner exemption might be the preferred – legal – option moving forward. On the other hand, should a cash poor startup desire to hold onto equity, contracting with individuals who have an independent trade and designing projects outside of its normal course of business may be the only way to avoid classifying a worker as an employee.

The Convertible Note: What It Is, Why To Choose It, and How to Use It

By: Chujia Yu

March 2018

        When entering into seed rounds (preliminary investment stage for startups to establish goals of their business), startups frequently use convertible notes to raise investment capital.  A convertible note is a debt instrument that can be converted into equity automatically upon certain conditions and/or at the option of the holder or issuer. Compared to traditional priced equity rounds (an equity-based investment round in which there is a defined pre-money valuation), a convertible note is a simple, cheap, and expedient method for startup funding.  Generally, it contains a maturity date provision specifying when the note should be repaid with interest.  Standard interest rates vary from 2% to 8%.  The maturity date is usually set at twelve to twenty-four months after the first convertible note investment.  Usually, when a convertible note has matured, the investor will choose to convert the principal of the note plus the accrued interest into equity.  Upon converting, investors choose converting methods between a conversion discount or price cap mechanism.

Why Not Common Stock

        People may wonder why the startups do not simply issue common stock to investors instead of a convertible note that will be converted into common shares upon maturity. There are three reasons startups may choose not to issue common stock.  First, the issuance of shares of common stock will create a dilution risk for the founders.  Since founders and investors often disagree on the value of the startup, it is hard to decide what percentage of ownership interest should be granted to investors.  If investors stand a stronger position and are hard to bargain with, founders will risk losing the control of the startup.  Second, issuance of stock may trigger negative tax implications.  If at the time of corporate formation, the founders issue themselves common stock at par value (which is generally fairly low) and shortly thereafter, issue common stock to investors for the investment (which is generally a large amount of money), the IRS may impute a much higher value on the shares issued to the founders and regard the excess amount over the purchase price taxable to the founders as ordinary income.  Third, issuance of common stock will assign value on the shares of common stock.  Thus, if a startup has a stock option grant plan in place, the recipient of that option will not be incentivized to stay and help create value for the startup.

Why Convertible Notes

        The significant step startups take in fundraising is to go through series rounds (A, B, C, etc.).  Series A round is essentially about revenue growth.  Generally, a company will be evaluated before each round.  However, with the issuance of convertible notes, the valuation process is postponed until the Series A round of financing is closed.  In addition, since a convertible note is essentially a loan, it will not trigger the above-mentioned tax problem.  What’s more, founders have no need to worry about losing control of the startup.  Convertible note holders are rarely granted control rights and have no minority shareholder rights.

        The advantages of a convertible note are clear as crystal.  However, it is still a bit difficult for people to understand the mechanics of convertible note conversion.  There are three key economic terms in a convertible note: (1) the conversion discount; (2) the conversion valuation cap; and (3) the interest rate. 

How Convertible Notes Convert

        The conversion discount is used to reduce the purchase price per share paid by the Series A investors.  It sets a percentage reduction to permit the note holder to convert the principal amount and accrued interest of their loan into shares of stock.  The discount ranges from 10% to 35%, with a common discount rate of 20%.  Suppose John the Investor invested $1 million into NewCorp, with no interest and a 20% discount for a 1 year term.  If during this one-year term, other investors pay $10 for one share and the conversion is triggered, then John only needs to pay $8 for one share, and his total converted shares would be $1 million divided by $8 per share, for a total of 125,000 shares.

        While the conversion discount is relatively easy to understand, the conversion valuation cap may be a little more complicated.  A conversion valuation cap sets the maximum valuation at which the investment made via the convertible note can be converted into equity.  It has the same purpose as the conversion discount, which is to permit the note holder to convert their loan plus interest at a lower price than the purchase price paid by the Series A investors. Using the same example above, suppose the cap was $5 million and the pre-money valuation (valuation of the company prior to an investment) in the Series A round were $10 million. In this case, John can convert the loan at an effective price of $5 per share ($5 million divided by $10 million) and thus receives 200,000 shares.  Given the fact that investors receive more shares using valuation cap than a conversion discount, a conversion valuation cap gives the note holder an opportunity to enjoy any increase in the value of the startup prior to the Series A round.

        If the qualifying transaction defined in the convertible note is triggered, the conversion will automatically take place.  However, in reality, things do not always go so smoothly. More often than not, founders reach the note’s maturity date before they can cause the natural conversion, at which point the founders may want to ask for an extension.  The first solution is to increase the interest rate, such as increasing from 7% to 10% to show a nice gesture to the investors.  The second solution is to add a valuation cap into the convertible note if originally one was not included.  But if the convertible note has a valuation cap in existence, the founders may have to offer a higher discount to make extension possible.  To conclude, a convertible note is an effective debt instrument to issue to the investors.  What startups need to master are the concepts of conversion discount and valuation cap.

How to Structure Employee Incentive Plans in Limited Liability Companies: The Easy Case, The Intermediate Case, and The “Messy” Case

By: Tyler Mills

March 2018

Timing Restrictions on Ownership and Why They Are Complicated in the LLC Context

Timing restrictions on stock ownership are commonly used by entrepreneurs in corporations. Start-Up Toolkit indicates that a four-year vesting schedule with a one-year cliff is a typical agreement that business founders and co-founders use to incentivize employees to stay invested in their work. This agreement means two things: First, to capture any equity in the company, the individual subject to the one-year cliff must work for at least one year; and second, the individual will begin capturing one-fourth of his or her promised equity at the end of each of the subsequent four years. Founders and co-founders that organize as corporations use vesting restrictions to ensure that other co-founders and employees remain actively involved in the company’s operations for a period of time before they can collect any equity. This should be familiar to those with experience in founders’ agreements and employee restricted stock agreements in corporations. However, an interesting question arises in the context of limited liability companies (“LLCs”) with regard to how founders and co-founders can restrict membership units for a period of time, thereby capturing the desirable effects of stock vesting.

First, it is important to understand some principles of LLC law. There are relatively strict restrictions on the addition of new members to LLCs, pursuant either to the LLC’s operating agreement or the default state law rules governing LLCs, which are generally based on the Revised Uniform Limited Liability Company Act (“RULLCA”), with slight variations. Typical provisions found in operating agreements, and most, if not all, default state LLC statutes, include that after the formation of an LLC, a person becomes a member as provided in the operating agreement or with the consent of all members and an LLC is not formed until and unless at least one person becomes a member. As a result of these commonly applicable provisions, it is best practice to structure arrangements, in this case Restricted Unit Agreements (“RUAs”) or unit rights plans, with the above-mentioned in mind.

The Easy Case: One Founder with Diluted Membership as Employees’ Units “Vest”

According to the National Center for Employee Ownership (“NCEO”), likely the easiest way to incentivize employees in the LLC context is through a RUA. In the easy case, there is one founder who owns 100% of the LLC’s membership interests. This satisfies the requirement that there be at least one LLC member upon formation. Then, the founder of the LLC will put in place a unit rights plan, which will grant an employee a hypothetical number of LLC membership interests—sometimes referred to as “phantom shares”—which will be subject to vesting over time. Please note that the terms “shares” and “vesting” are used only by analogy to ownership timing restrictions in corporations because, according to the NCEO, “There is no agreed-upon legal definition for what these would be called in an LLC.” Similar to corporate vesting, as a percentage of membership units begin to “vest,” the original founder’s 100% membership interest will be diluted to make way for additional members. Structuring a RUA in this way will adhere to the principles of LLCs set forth above; specifically, that there be at least one member at the moment of formation and that all existing members will have agreed to add this new member.

The Intermediate Case: Timing Restrictions on Co-Founders’ Ownership with Some, But Not All, Membership Initially Accounted For

            The intermediate case may arise when there are two or more co-founders, each who wishes to incentivize the other co-founder to stay on board. In this scenario, the structure of the RUA may look something like this. First, the two co-founders grant each other a percentage ownership of the LLC at the moment of formation, say 25% each. This satisfies the RULLCA requirement that there be at least one LLC member upon formation (and distinguishes the “messy” case below). Then, the remaining 50% ownership may be subject to timing restrictions. For example, each co-founder will capture one-fifth of the remaining membership over five years. Put differently, each co-founder’s membership interest will increase by 5% in each of the subsequent five years until all 100% is accounted for. By structuring a RUA in this way will similarly adhere to the principles of LLCs set forth above; specifically, that there be at least one member at the moment of formation and that all existing members will have agreed to add this new member.

The “Messy” Case: Timing Restrictions on Co-Founders’ Ownership with No Membership Initially Accounted For

The “messy” case results when entrepreneurs put a RUA in place, without fully understanding the implications of LLC law. Take the following example. There are two co-founders and each desire membership in the LLC. The LLCs operating agreement lists both as members, each with a 50% membership interest in the LLC. There is nothing wrong with this arrangement so far, as this is a very typical LLC ownership structure. However, suppose each co-founder would like the other co-founder’s membership interest to be subject to a unit rights plan or RUA. To accomplish this, the two co-founders agree that each of their 50% ownership will be subject to timing restrictions, for example a one-year “cliff.” As a result, technically, at the moment of formation there are no LLC members, therefore not satisfying typical LLC principles explained above, and in the RULLCA. Put differently, in this scenario, no co-founder owns any membership interest yet and as such the LLC technically has no members.

In the messy case, the question becomes: What would happen if the company dissolved before the “vesting” of any membership interests. Recall that in the easy case the only member prior to the employees’ membership vesting was the company’s founder. As such, in the event of dissolution before vesting, the founder would collect all of the company’s assets. Similarly, in the intermediate case, where each co-founder owns 25%, and the remaining 50% is subject to timing restrictions, there is a clear membership breakdown. As a result, in the event of dissolution before vesting, the co-founders would each collect 50% of the assets. However, because in the “messy” case there are technically no members until the co-founders’ units vest, what would happen to the company’s assets if it were to dissolve is unclear. This question is best answered by using doctrines governing contract interpretation. According to Vincent R. Martorana, to accurately interpret a contract, one must “determine the intent of the parties with respect to the provision at issue at the time the contract was made.” Therefore, a court would presumably defer to the agreement underlying the RUA. Specifically, although no membership had vested, each co-founder entered into the agreement under the assumption that at some point in the future they would each own 50%. In light of this understanding, a court would likely find that, although the LLC technically had no membership at the time of dissolution, each co-founder is a 50% member to whom 50% of the assets would distribute upon liquidation. 

A Recommendation for Entrepreneurs

Although the overall recommendation of this post is to structure employee membership subject to timing restrictions in accordance with the easy case—the unit rights plan laid out by the NCEO—or the intermediate case, it was also important to address the “messy” scenario in case an entrepreneur finds him or herself in that situation. To implement the best ownership structure to incentivize other co-founders and/or employees via RUAs, entrepreneurs should ensure that they understand the general provisions of the LLC’s operating agreement, the default state laws with respect to LLCs, and the RULLCA. Only after understanding the requirements for LLCs with respect to membership can an entrepreneur-founder structure the LLCs ownership to avoid the “messy” case.

The Evolution of Genetic Health Testing Regulation

By: EIC Student

January 2018

After the completion of the Human Genome Project in 2003, a Silicon Valley-based startup developed and began commercializing a genetic health test kit.[1]  With the aim of democratizing personal health care data and empowering consumers, the startup bypassed the medical provider community and marketed their genetic health test directly to consumers.[2]  This was a disruptive game-changer—the test kit provided insight into a given consumer’s ancestry and a prospective outlook of their genetic predisposition to several diseases and conditions.[3]  After raising a considerable amount of capital, bringing on a team of Silicon Valley veterans, and developing a product capable of testing for more than 250 diseases and conditions, it all came to a screeching halt with a warning letter from the Food and Drug Administration (“FDA”).[4]  For disruptive startups in a highly regulated industry like health care, regulatory ambiguity cuts both ways—it can present as tremendous upside potential or, conversely, predispose a company to an early demise.

Stunted Growth

The direct-to-consumer genetic testing market came to a standstill in November 2013.  The FDA issued the aforementioned warning letter to 23andMe—a pioneer of direct-to-consumer genetic health testing—and declared their genetic health testing kit to be in violation of the Food Drug & Cosmetic Act (“FD&C Act”). [5]   A warning letter is an official FDA notification issued to a company after the agency has identified a significant violation, which then requires the company to address the violation and communicate a remediation plan within a given timeframe.[6]  Pursuant to section 201(h) of the FD&C Act, the FDA declared 23andMe’s genetic health testing kit to be a device based on its intended “[u]se in the diagnosis of disease or other conditions or in the cure, mitigation, treatment, or prevention of disease, or is intended to affect the structure or function of the body” and, therefore, in violation of the FD&C Act because it had “[n]ot been classified and [required] premarket approval or de novo classification.”[7]  As a result, the test kit was effectively reduced to a genetic testing tool for ancestry.[8]

Learn and Adapt

In 2015, in a first step for the FDA, the agency approved the first direct-to-consumer genetic carrier test—a category of genetic health testing focused on consumers who may be at risk for passing on a recessive genetic disorder to their children (e.g., Bloom Syndrome).[9]  This approval was based on two policy rationales that must be included as strategic imperatives for any startup planning to enter the genetic health testing market.  The first is grounded in consumer access.  The FDA has taken the position that in “[m]any circumstances it is not necessary for consumers to go through a licensed practitioner to have direct access to their personal genetic information.”[10]  To that end, this category of genetic health testing has been exempted from pre-market review.  The second policy rationale is grounded in consumer safety and protection.  In its approval, the FDA placed carrier genetic tests in a lower device classification (class II) to reduce the regulatory burden and, therefore, subjected this category of genetic health tests to general and special regulatory controls designed to ensure safety and effectiveness.[11]  In an effort to further enhance consumer safety and protection, the FDA required the genetic carrier test to present test results in a way “[t]hat consumers [could] understand and use,” and include a product label explaining what the results could potentially mean.[12]  This is akin to the approach the FDA utilizes with other direct-to-consumer tests (e.g., pregnancy tests).[13] 

Dynamically Evolving  

These twin policy aims are the underpinnings of FDA’s evolving approach to regulating direct-to-consumer genetic health tests—now referenced as genetic health risk tests, or “GHRs.”  Consumers are becoming more engaged in their own health care in many ways, such as counting their steps, tracking their heart rates, and monitoring their sleep patterns—just to name a few.  And, similar to these new technology-derived insights, GHRs also present an opportunity for consumers to learn more about their health and make more informed lifestyle choices.[14]  However, the public health benefits of increased consumer engagement and access to personalized health care insights also presents a unique challenge.  As the FDA Commissioner has stated, “[t]hese technologies don’t fit squarely into our traditional risk-based approach to device regulation.”[15]

In April of this year, the FDA approved the first direct-to-consumer GHR for ten (10) diseases and conditions, which includes Parkinson’s disease, late-onset Alzheimer’s disease, and Celiac disease.[16]  Like the aforementioned genetic carrier test approval, the newly approved GHR is subject to general and special controls to ensure safety and effectiveness.[17]  Both approvals granted marketing rights to the same trailblazing startup—none other than 23andMe.  And, with this approval, the agency signaled its plans toward regulating GHRs.  That is to say, the FDA exempted “[a]dditional 23andMe GHR tests from FDA’s premarket review” and stated that tests “[f]rom other makers may be exempt after submitting their first premarket notification.”18

The regulatory shift to reviewing and approving the company manufacturing the genetic health test, rather than the specific test itself, was reinforced in FDA’s recently announced plan to streamline the development and regulatory pathway of GHRs.19  The agency intends to implement “[a] novel regulatory approach…that applies proper oversight in a flexible, new way.”20  In other words, the FDA plans to execute a one-time review of a company to ensure it meets certain FDA requirements and, once approved, subsequent tests from an “FDA-approved” company will be exempt from premarket review.21  The implications of this “firm-based” regulatory framework22—similar to that of the digital health pre-certification pilot—will allow GHRs to enter the marketplace, and strikes a balance between the aforementioned twin policy aims of consumer access and consumer safety and protection. 

Conclusion

Regulatory ambiguity can present as an unwelcomed malady threatening a startup’s viability, while also presenting as an opportunity to disrupt an industry and engage with regulators to shift the traditional paradigm.23  The recent regulatory shift provides clarity to entrepreneurs entering the direct-to-consumer genetic health testing market.  And, unlike more established startups in this rapidly evolving industry—“established” is a relative term—newly funded startups have more clarity on what processes, methodologies, and controls must be in place prior to engaging with regulators.  This translates to smarter capital allocation and more predictability in developing and executing a go-to-market strategy.  In other words, startups now have a better understanding of the “input” needed to secure FDA approval.  Therefore, this four-year evolutionary snapshot of the genetic health testing regulatory framework highlights the risk of regulatory ambiguity, and the important impact startups can have in shifting the landscape.

[1] Wired (Nov. 2007)

[2] Fast Company (Oct. 2015)

[3] Wired (Nov. 2007)

[4] Fast Company (Oct. 2015)

[5] FDA Warning Letter (Nov. 2013)

[6] FDA Warning Letter FAQ (Nov. 2017)

[7] FDA Warning Letter (Nov. 2013)

[8] Fast Company (Oct. 2015)

[9] FDA Press Release (Feb. 2015)

[10] FDA Press Release (Feb. 2015)

[11] FDA Regulatory Controls (June 2014)

[12] FDA Press Release (Feb. 2015)

[13] FDA Press Release (Feb. 2015)

[14] FDA Commissioner Statement (Nov. 2017)

[15] FDA Commissioner Statement (Nov. 2017)

[16] FDA Press Release (April 2017)

[17] FDA Press Release (April 2017)

18 FDA Press Release (April 2017)

19 Stat News (Nov. 2017)

20 FDA Commissioner Statement (Nov. 2017)

21 FDA Commissioner Statement (Nov. 2017)

22 FDA Commissioner Statement (Nov. 2017)

23 Fast Company (Oct. 2015)

Law Firms Must Adapt to Remain Relative

By: Stephen Anderson

January 2018

Law and Tech

Much like oil and water, the legal industry and technology have never seemed to be very compatible.  Whether it is the outdated filing systems in many courts around the nation or the hesitation to make use of new technology, our country’s legal framework has failed to utilize the significant leaps in technology that have taken place over the past few decades. Regardless of the reason, this is cause for concern. However, slowly but surely, technology has started to become integrated into the law and its administrative framework in recent years. Specifically, some legal technology startups have made some serious inroads into these law firm silos.

Overall, legal tech startups are growing in prominence and sheer size.  Arguably, the most impressive aspect of tech startups is the multitude of ways they are affecting the legal industry.  Online service providers, such as Rocket Lawyer, have become mainstream, alternative options for straightforward legal aid.  Legal markets such as Intellectual Property software and practice management software have all seen a large increase in the presence of startups.  Additionally, new markets such as eDiscovery can attribute their rise (and, to a certain extent, their existence) to legal tech startups.  This is only the beginning.  The legal industry is in a dire need of a technological disruption, by which, legal tech startups may improve on a variety of aspects of the industry.  A great example of such potential is Relativity, formerly known as kCura. [1]

The Potential of Relativity

At a basic level, Relativity helps law firms and corporations organize data through their eDiscovery software platform, which subsequently cuts their costs and saves them significant time.  Although that may sound simple enough, the ability to comb through data in a much more efficient manner is priceless for law firms.  While Relativity’s current business plan is exciting, it may be just the tip of the iceberg. 

The eDiscovery market is primed to take off.  The market is estimated to become a $20 billion-dollar business within the next 5 years, and many eDiscovery companies are not going to stop at legal.  They believe there is opportunity for growth into a number of different industries. [2] If that is not exciting enough, the real potential lies within Relativity’s platform. Simply put, their platform has the ability to play a large part in the continued growth of legal tech startups.  

To better appreciate the potential that Relativity’s platform provides, it is first necessary to understand Relativity, and its many capabilities, itself.  The company and its suite of products revolve around data, and their ability to quickly utilize that data in a number of different ways that are useful to law firms and companies alike.  To give a frame of reference on the amount of data that Relativity manages, here are a few statistics.  They have 95 billion files under management, over 160,000 active users, and over 13,000 unique organizations that use the Relativity platform.  Additionally, 75 of the Fortune 100 companies and 195 of the Am Law 200 use Relativity. [3].  Whether a law firm needs to prepare evidence for litigation or work through corporate data pertaining to a merger, Relativity’s eDiscovery software is key to their tasks.  Needless to say, Relativity is already having a significant impact on the legal industry.  Now, their platform could make that impact even larger by supporting not only their own product, but those of other tech startups, as well.

The Hub: Relativity’s Playground

The platform allows third parties, such as legal support professionals, independent consultants, and software providers, to extend Relativity’s functionality by integrating applications into the platform.  They do this under an umbrella they call the Relativity App Hub (the “Hub”).  The goal of the Hub is to allow Relativity’s users to have options regarding solutions to a number of problems they may face across the various stages of eDiscovery.  The possibilities do not end there.  While the platform is used for eDiscovery, the Hub also fosters applications aimed at solving data challenges outside this service.  All of these applications are prime examples of innovative solutions to the traditional legal framework.  The process is relatively simple.  Once you are a Relativity client, you have access to the Hub, which integrates the applications made by separate tech startups onto the Relativity platform.

A brief look at Relativity’s website shows applications that can be utilized on their platform, with a variety of potential uses ranging from contract analysis to project management. [4] Take for example Heretik, an application for contract review utilizing machine-learning capabilities. [5] As such, Heretik expands the scope of Relativity by allowing consumers to have more efficient and cost effective contract review across a number of teams by eliminating tedious tasks that are essential to contract review.  Although this may sound simple, the heart of its accomplishment should not be overlooked.  Eliminating time-consuming tasks through machine learning allows law firms to allocate human capital and financial resources to much more important and useful tasks.

At the end of the day, the biggest challenge for Relativity and its competitors is educating its consumers.  As previously discussed, law firms are notoriously resistant to change.  As a result, Relativity and its Hub represent an innovative solution to the steep learning curve that accompanies much of new technology nowadays. Law firms will not have to spend time (and money) to teach their lawyers and professional staff how to use any unfamiliar software that is built on the Relativity platform.  The staff will be familiar with Relativity and, therefore, should learn how to operate any new applications on the Hub seamlessly.  Most of the applications on the Hub will include another paywall, but the decision regarding whether or not to pay additional fees is one for Relativity’s clients to make.  For savvier clients, the Hub also gives them the ability to create their own custom Relativity applications.  The fact that law firms now have these options is an achievement in and of itself that should be celebrated.

Future Aspirations

Lets face it - a lawyer learning new technology can be a recipe for disaster.  Generally speaking, it is in our nature to become accustom to a certain way of accomplishing certain things, especially in regards to technology (look no further than Apple dependency and many peoples reluctance to use and fully utilize Excel).  Lawyers and the law industry are no different.  Although a platform such as Relativity has not been utilized (or scaled) in the legal industry before, Relativity and its supporters should look to Salesforce as inspiration.  Salesforce is clearly much bigger than Relativity, but, nevertheless, it has had a number of successful companies built on top of its platform.  They may not reach the same heights, but at the very least there is a successful blueprint readily available.

At the end of the day, the benefits provided by legal innovations improve the services provided to the client.  Law firms save time and money, Relativity cultivates innovation in the legal tech startup space, and lawyers themselves are able to purse through and utilize data that in a more efficient manner than ever before. Simply put, law firms, big and small alike, will (eventually) use technology reflective of the time we live in.  In order to improve client service, the standard in the legal industry should be to remain abreast of available technological services. Tech startups are at the heart of that aspiration and Relativity is an early example of a company providing a means for them to reach the legal world.