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

By: Tyler Mills

May 2018

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

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

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

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

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

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

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

Inherent Defect of Board Designation Strategy: Fiduciary Obligations

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

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

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

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

STARTUPS AND TRADEMARKS: THE CONFUSION AROUND LIKELIHOOD OF CONFUSION

By: Gabriella Falcone

May 2018

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

Likelihood of Confusion Simplified

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

The Analysis

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

1.      Similarity of the marks

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

3.      Similarity of trade channels used

4.      Care used by buyers when purchasing

5.      Fame of the registered mark

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

7.      Nature and extent of actual confusion

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

9.      Variety of goods on which a mark is used

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

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

12.  Extent of potential confusion

13.  Any other facts probative of the effect of use

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

How to Overcome a Likelihood of Confusion Rejection

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

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

Conclusion

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

Entity Formation: Starting Points for Tech Startups

By: Eitan Davis

May 2018

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

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

The Two Basic Types of Business Entities

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

LLC

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

C-Corporation

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

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

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

Investors

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

Special Tax Treatment

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

Liability

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

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

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

By: Eitan Davis

April 2018

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

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

What is Fiscal Sponsorship? 

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

Two Common Forms of Fiscal Sponsorship

The Direct Project

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

Preapproved Grant Relationship

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

Maintaining Control

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

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

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

Know Thine Sponsor

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

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

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.