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. 

The KOM of Data Privacy and Utilizations

By: Esteban Múnera

December 2017

The Big Data Challenge

Data privacy was once viewed primarily as a narrow legal niche, mainly relevant for a handful of industry segments, with very little impact on most lawyers and most companies.  Today, particularly in the past few years, data privacy and security have become regular front page news with the need for substantial attention in virtually every company.  Behind the scenes, regulators vie for jurisdiction on enforcement issues, and legislators at all levels attempt to balance between personal interests and the potential gains for society from data.  As a result, you cannot run a meaningful company without an effective information security program. By the same token, you cannot benefit appropriately from the information available to you without understanding how privacy laws and regulations impact big data and overall data analysis.

The big data challenge involves both private enterprise and government seeking greater insights into people’s behaviors and sentiments which may aid product and process discovery, productivity, and policymaking.  This post will provide a primary overview of the legal considerations of data privacy.  U.S. and international privacy regulations aside, all lawyers must advise their respective clients on potential data privacy threats and beneficial utilizations.  As the example below illustrates, this line between privacy and utilizations is not always clear and constantly changing.

Case Study: Strava

            In 2009, Strava, launched their site, and opened a virtual community for athletes.  “The Social Network for Athletes”, is a website and mobile app used to track athletic activity via satellite navigation and compete virtually against other users (e.g., King of the Mountain segment challenges, or “KOMs”).  There are a number of features available which include the ability to search the database for routes, athletes, and local challenges.  Athletes can “follow” each other and activities are automatically grouped together when they occur at the same time and place (for example, taking part in an organized marathon/sportive or group run/ride).  In addition, athletes can give “Kudos” (similar to a Facebook Like) and comment on each other’s activities, and upload photos to activities.

This year, Strava celebrated a major milestone: the one-billionth activity shared to their social network for athletes.  As a rapidly growing social network for athletes, Strava saw one million new users every 40 days, and athletes share a staggering average of 1,382,138 activities per day. Athletes on Strava have covered 12,967,788,011 miles—the equivalent of 54,281 trips to the moon! And if you thought Instagram was the only player in the social network space, the platform also sees a whopping 17 million feed views per day, 55 million comments and kudos each week, and 2.2 million photos uploaded per week.[1]

The Business = Data

Although Strava offers a premium subscription business, most users are “weekend-warriors” who opt for the free service option.  Premium subscription according to Strava is for “the athlete who squeezes every drop out of their sport” through advanced data analytics.[2]  Unsurprisingly, these premium perks prove to be superfluous and financially prohibitive for the majority of its consumer base.

In addition, unlike online music providers, Strava is completely add-free for both premium and non-premium users.  Strava’s new CEO, James Quarles, explained that ads are not where he is steering Strava’s business line.  He believes that for ads a certain kind of scale and user expectation is needed.  He should know - Quarles brings to Strava invaluable experience as most recently the VP of Instagram Business and previously Regional Director of Facebook in Europe, the Middle East and Africa.

So how does Strava make money?  As the Quarles explained, it has a “metro business” (Strava Metro) which aggregates and anonymizes commute data to sell back to a city’s department of transportation so they can better plan pedestrian bicycle routes in cities.  Although it may see like Strava Metro is a broad departure from its primary service, this invaluable data has the potential to inform every respective athlete’s city on questions of infrastructure.  It is the most powerful example of advocacy and awareness.  In the long run, pun intended, the tracked data will lead to new bike paths, bike lanes, and improved infrastructure

So, as with any social network – as the community grows, the types of business and data abstractions will grow.  But with the good, comes the bad.

Location-Based Dangers – The Strava Run Map and FlyBy

As a lifelong runner, I’ve become adept at predicting the best times, routes, and strategies to jog in cities while avoiding street impediments.  From circumventing stops at traffic lights to seeking quiet streets, I have adopted behaviors that may put my personal safety at risk.  To make matters worse, Strava may broadcast the route of my daily runs, including the starting location (i.e., my home address).  Furthermore, the new Strava Flybys feature allows you to see your run/ride, plus the run/ride of anyone else you ran/rode with, or who crossed your path.  So even if you were on the same road for just a couple of minutes, you can then view where the other athlete went.

To help combat privacy threats, Strava allows its users to customize the information he or she shares to satisfy the balance between being social and being private that feels right to the user.  The issue is that many users still do not understand how public their activities on the site are.  There is a misconception that since this a platform for athletes, there are no bad actors using the information available to them.  This is simply not true.

For Flybys, athletes can specifically opt-out of being part of Flybys features by selecting the appropriate option under their privacy settings area. f they do this their activity is not included in any Flyby replays.  Again, the issue is that many users do not know about this function or its opt-out option.  The Flybys feature is not part of the main platform, instead it is only available via a link on individual activity pages.

Creative Solutions

Privacy controls should not be an issue an active user, such as myself, should have to Google.  Like the modern trend in writing and displaying legal terms and conditions, privacy control options should be presented at the inception of a new account in a clear and plain manner.  These options should include direct implications of a user’s choice.  For example, choosing a private account setting control does not necessarily exclude your activities from public segment and challenge leaderboards.

Recently, Strava has responded to feedback from its community with a new feature, Beacon.  This service provides Premium members the ability to turn on Beacon before an activity, which allows up to three safety contacts are able to see their location on a map in real- time.  The problem, however, is that the majority users are not Premium members.  Creative solutions like Beacon, or some non-premium variety, need to be uniformly applied for all its users.  Personal and data security is a threat to all – no matter the athletic ability.

[1] https://blog.strava.com/2016-stats/

[2] https://www.strava.com/premium

“MAP” Agreements: an arrow in your quiver

By: Benjamin Ruano

December 2017

Entrepreneurs with a steadfast vision of introducing into the marketplace a uniquely useful or innovative product — those who skillfully craft its every contour and element of design, scrupulously examine and select its component parts, and exuberantly market the product to consumers and investors — understandably become crestfallen upon seeing their product advertised by retailers for much less than their suggested retail price.  This scenario represents more than a mere stab at one’s ego or emotions, it may even adversely impact a nascent business.  Entrepreneurs and manufacturers, however, have a potentially useful arrow in their quivers to contend with this dismaying situation: Minimum Advertised Price (“MAP”) agreements.

Of “value” and “price”

Most, if not all, things have no intrinsic value; “value” is a human construction, the argument goes (pardon the philosophical conjecture, but there is a point to this). “Value” in the marketplace, then, may be seen as an edifice of worth erected by consumers, retailers, entrepreneurs, advertisers and manufacturers alike.  For instance, a consumer may perceive a product’s value (and the price she is willing to pay) to be much higher than the value or price a retailer ascribes to the same product. 

As droves of consumers, retailers, manufacturers, and the like, proceed to weigh-in on their perceived value of a given product, over time the outward-facing sticker-price will begin to approximate and reflect the aggregated view of marketplace actors.  This is a manifest oversimplification of how goods and services are priced (lest We forget supply and demand); but it is nevertheless a useful exercise in coming to terms with the fact that the prices of products you put forth into the marketplace are often in discord with how you as entrepreneurs value them.  Indeed, in the aftermath of cold appraisal by rational actors—whom are largely disinterested in the viability of your company—you may not always end up with a price with which you are content. 

To wit, there is a great tension between the aims of retailers and manufacturers. Retailers are in a highly competitive market and face pressures to advertise and sell at the lowest possible price; entrepreneurs and manufacturers, meanwhile, desire strong sales but also rely on particular price-floors to draw accurate revenue projections and confidently enter into financing agreements—and in some cases, to merely stay afloat.

A primer: “MAP” Agreements

Some market participants, such as large retailers that both advertise and sell products (e.g. Target and Amazon), have a disproportionate impact on where the price-dust settles.  If certain products are being advertised (and sold) for far less than cost, it can hurt brand and product value while also hurting other retailers who are selling a product at MSRP (“Manufacturer Suggested Retail Price,” typically the total cost of producing a product plus an embedded profit margin).  In a competitive marketplace, this scenario spurs a “race to the bottom” for retailers just looking to make sales by dramatically undercutting on price; this is especially critical for online retailers who more frequently are faced with new competitors.1 In an effort to guard against this “race to the bottom,” Minimum Advertised Price (“MAP”) agreements were conceived and quickly began to sprout about the marketplace.  “MAP” is the lowest price a retailer can advertise a manufacturer’s product in online ads or print – note, this does not affect the price at which a certain product can be sold while in-store. 

There are many pros linked to “MAP” agreements for manufacturers and retailers: 2   

For Manufacturers

For Retailers

Protects brand equity

Maintains product value

Eliminates free-riding

Controls downstream prices

Coordinates channels prices

Protects profit margins

Prevents price cascading

Helps marketing efforts

Drives revenue growth

Collusion? Hardly.

Since minimum advertised pricing only relates to advertised pricing and does not tell a retailer at which price they can actually sell it in their store, this type of collusion between manufacturers and retailers is perfectly legal under U.S. antitrust statutes.  Departing from a 96-year-old precedent, the Supreme Court of the United States in Leegin Creative Leather Products, Inc. v. PSKS, Inc. (2007) found that such agreements actually promoted competition and were per se “legal” – the only exception lying in situations where the price agreements are abused for illegal anticompetitive purposes, determined on a case-by-case basis and analyzed under the Court’s “rule of reason” standard.3

Two items are relevant to note: First, unauthorized retailers—those with no formal relationship with the manufacturer—are not bound by “MAP” agreements.  Second, that online retailers have figured out a way to sell products for prices below “MAP” and skirt such agreements, with the blessing of the Federal Trade Commission (“FTC”) and the courts.4  In short, the FTC says that the price displayed in a secure or encrypted shopping cart is not subject to “MAP” agreements because it is technically not “advertising” once in a private cart.  Have you ever seen, while online shopping, text to the effect of “price displayed in shopping cart?”  You can thank a savvy lawyer for that.

To “MAP,” or not to “MAP”? An entrepreneur’s soliloquy.  

A written, formally-executed “MAP” agreement between a manufacturer and retailer stating minimum pricing not only carries the potential benefits enumerated above, it also bears all the hallmarks of a contract - including legal remedies for noncompliance. This is somewhat comforting, but one taking this route must contemplate the legal costs associated with drafting a bespoke agreement, as well as the possibility that a retailer will eschew doing business with your company entirely, in terse response. 

By comparison, in the event that no “MAP” agreement is signed, manufacturers have far less authority, and legal backing, to enforce their regulations or purely internal policies.

There is also the issue of enforcement.  Supposing a “MAP” agreement was entered into and a retailer advertised your product below “MAP,” you would be entitled to pull your products from the retailer and restrict them from selling the product again.  (Which begs the question: how many entrepreneurs have the constitution and willingness to pull a successful product from a big-box store or online marketplace?)  Moreover, if dozens (or hundreds, or more) of these agreements are executed, consistent enforcement can be unruly and costly.  Yet, by not consistently enforcing them you may inadvertently suggest to your retailers that they can renege on the agreement with impunity, effectively defeating your original purpose. 

Nevertheless, these agreements seem to work.  A recent study on this topic, undertaken by researchers at the Kellogg School of Management, revealed that just 15% of authorized retailers do not comply with their “MAP” agreements.  As a best practice, the researchers suggested, manufacturers should have “a little flexibility” in “MAP” pricing definitions, which can actually benefit all parties.  Manufacturers should understand that retailers are competing for business, and in consideration of this there may be a stipulation, for example, that a retailer is in violation only if it prices a specific product at least $10 lower than the “MAP”.  Such flexibility might make it easier for the retailer to agree to enter into the agreement and might help manufacturers direct their limited resources at more egregious “MAP” violations.

Ultimately, affixing your best business judgment to the question of whether or not you should implement a “MAP” agreement is a worthwhile initiative—particularly as regards the “value” of your product.  Indeed, by utilizing a “MAP” agreement you can at least afford yourself a more pronounced say as to what “value” (and price) you think your product should be accorded in the marketplace.

Deregulating the Entrepreneur

By: Tyler Archer

December 2017

A robust entrepreneurial spirit is a defining characteristic of American workers and businesspeople—and with good reason. Of the roughly 25 million businesses operating in the United States in 2015, about 23 million were sole proprietorships or partnerships.[1] Ninety percent of American companies have fewer than 20 employees[2] and companies with fewer than 500 employees account for roughly 65% of all net new jobs.[3] Half the American workforce clocks in everyday at a small business.[4] The statistics roll on – America is a small business nation.

Elected officials on both sides of the aisle often sing the praises of small businesses, but less often they pass laws or support reforms that could make it easier for small businesses to do what they do best: allow individuals to make their dreams reality. Perhaps the best example of a well-intentioned government action getting in the way of the entrepreneur is occupational licensing. For a growing list of occupations, government permission is required to enter the market. A recent 50-state survey of occupational licensing found that for over one hundred jobs the average requirements included $200 in fees, nine months of training, and at least one exam.[5] The report offered two other important findings. First, occupational licensing is random: only 15 of the studied professions are licensed in 40 or more states and the average job only requires a license in fewer than 25 states. Second, the difficulty of entering a profession often does not correspond with its perceived difficulty or the health and safety risks. One notable example in Massachusetts is that Barbers requires ten times more training hours than EMTs. These inconsistencies raise questions about whether licenses are necessary for public safety or result from political motives such as cronyism—wherein established businesses benefit from making it more difficult for competitors to enter the market.

To make matters worse, occupational licenses tend to disproportionately impact low- and moderate-income jobs. One illuminating story comes from Tupelo, Mississippi.[6] In 1995, Melony Armstrong, a young African-American mother of four, wanted to open her own business braiding hair in styles common among Africans and African-Americans. To become a braider, Melony completed 300 hours of coursework—though none covered braiding—to earn her wigology license. After years as the state’s only braider, Melony wanted to pass her skills on to the next generation of young African-American girls. In stepped the government. The state’s Board of Cosmetology required Melony to obtain a cosmetology license (an additional 1,200 hours), then a cosmetology instructor’s license (another 2,000 hours), and then apply for a school license. None of these 3,500 hours covered anything related to braiding or teaching others how to braid. Melony had had enough and filed a lawsuit to break down these regulatory barriers. In 2005, the lawsuit ended when Mississippi Governor Haley Barbour signed legislation allowing braiders to practice and teach their craft without any workshop hours, license, or school—just a $25 registration fee and continuing compliance with state and local health codes. Since 2005, 300 other women have opened braiding businesses in Mississippi, thereby gaining financial independence under the banner of entrepreneurship. Melony’s story has become the prime example of the cumbersome barriers-to-entry government erects in the face of entrepreneurs and what can happen when it gets out of the way.

 Excessive or poorly implemented regulation is another way well-intentioned government actions can impede entrepreneurs. Moving beyond the everyday complaints of monotonous paperwork and “bureaucracy” easily found in workplaces around the country, recent studies have attempted to find empirical evidence of the dampening effect regulations can have on small businesses. The evidence appears most readily when considering how legislators and bureaucrats draft regulations. In general, as a business grows it triggers more and more regulation. Two of the most common triggers occur at 50 and 250 employees. For many businesses on these margins, the additional regulatory cost of hiring that next employee can outweigh the benefit that employee would bring, and small businesses choose to delay expansion. This plays out in Department of Labor statistics on the distribution of private small businesses by employee-size. In what would otherwise be a relatively flat distribution for firms, two bunches appear at sizes 20-49 and 100-249, just before these “regulatory cliffs”.[7] This is not just an American phenomenon. A recent study of French small businesses by the London School of Economics revealed this bunching effect—but to a more dramatic degree.[8]

For the wonkier among us, in a first-of-its-kind study, economists at George Mason and Duke universities attempted to estimate the cumulative cost of regulations on the American economy.[9] By analyzing 22 industries over a 35-year period, they estimated that regulations have reduced the economy 0.8% annually—roughly 25% in total—translating to $4 trillion in lost economic growth in just one year. Put another way, that is roughly $13,000 per capita.

None of this is to say that all licenses or regulations are bad, or that we would be better off with an unfettered free-for-all. Certain benefits—such as environmental and human health—are difficult if not impossible to measure in economic terms. Rather, data and stories like the above should serve as lessons for legislators and regulators, and encourage them to consider the individual impacts of the laws and rules that they propose, as well as the overall regulatory burden they place on the economy.

Re-assessing occupational licensing is an easy option. Another could be designing future regulations to take gradual effect rather than at steep bureaucratic cliffs. Increasing accountability by putting regulations up for periodic review or requiring particularly costly regulations to have legislative approval are just some of the many ideas to modernize and streamline the way governments interact with and effect small businesses. If our lawmakers can focus on reducing barriers to entry, easing pressure on marginal firms, and limiting the corrupting power of cronyism, entrepreneurship will continue to be a driving force in the American economy, improving people’s lives and solving many of the problems bureaucrats seek to address in the first place.