Legal Issues for Internet Start-up Ventures

Some Traditional Issues for Start-Ups

Some New Twists


Some Traditional Issues for Startups

Selecting the correct legal entity - think of the next steps
Any new venture will need to consider how it will be organized. This entails choosing the correct legal entity to operate the business. Many entrepreneurs naturally assume that forming a tax efficient entity, such as an S corporation or LLC, in their home state is the most sensible first step. In fact, depending on the short term and long term goals of the business, it may make sense to incorporate in a different state and adopt one legal entity over another. For instance, as a general rule, if the venture is intending to raise venture capital financing in the relatively near future (say, within the next 12 months), it would make most sense to chose a corporate entity that is most suited to venture capital financings (such as a C corporation incorporated in either the state of California or Delaware). Venture capitalists invariably require numerous controls and restrictions over a company to protect their investment and will usually insist on investing in a corporate vehicle that is tried and trusted and in a jurisdiction where there is a substantial body of law on corporate governance (such as California and Delaware). C corporations are particularly attractive to venture capitalists because of the relative ease with which preferred series of securities can be created to attract investors and yet still preserve the ability to offer favorably priced options to employees. There are many tax considerations to take into account which may override these financing considerations, particularly if investor capital is not going to be sought for some time. However, many Internet start ups are bypassing traditional growth and financing models because of the need to move at "Internet speed" and raise significant investment capital immediately to build market share in a new area of commerce. For these companies, choosing the wrong corporate entity can lead to unfortunate delays and legal, tax and cost disadvantages involved in switching from an existing corporate entity to one preferred by investors.

Founders Agreement - commitment to the venture
It will be very important to ensure that the founders of the new venture are all on the same page when it comes to their relative interests in the venture and their commitment as to its future. It is the new venture's equity which drives founders to give their all to the venture and thus how that equity is initially divided and held is critical. A Founders Agreement deals with such issues as the relative split of the equity between the founders and how long they have to serve the company in order for this interest to fully vest. Generally it is important that all founders be subject to vesting as this helps ensure continued commitment to the company. In the event one of the founders leaves, the remaining founders will need the departing founder's equity to offer to a replacement. However, you should consult in advance with your tax advisors with regard to any vesting restrictions for the founders as there are some important tax considerations to take into account (for instance, the potential need for the IRS filing commonly referred to as an "83(b) election"). The Founders Agreement would also commonly control the ways and means in which the founders exercise their voting rights and any transfer or sale of their interest in the venture.

With so many new ventures springing up on the Internet and so many new opportunities for entrepreneurs, it is all the more important to tie in your fellow founders to the cause. With the potential for significant and even meteoric rises in valuations for Internet ventures, it is more important than ever to get the right tax treatment for founders' stock.

Stock Options - give away pieces of the company carefully
Without doubt the most common issue that I come across with start-up ventures is problematic stock option grants and plans. It is essential for any Internet start-up to create a stock option plan that creates a "currency" to attract and retain qualified employees. Competition for these employees is particularly fierce and equity incentives (perhaps even more than cash and benefits) are a deciding factor in attracting new talent. It can also be important in attracting the services of high level consultants to the company for specialist duties, as has been the case recently with who obtained the services of the well known actor William Shatner as a spokesperson, in part through providing him with rights to purchase the company's stock. However, there are many pitfalls for the unaware or poorly advised. In our experience some of thorniest issues are created by well intentioned promises to give an employee "a percentage of the company" without any thought to vesting, dilutive effects of raising investment capital and tax and accounting treatment. These vague promises often result in acrimonious and expensive disputes that usually cost the venture much more than a well prepared stock option plan. Stock options are also securities and thus compliance with federal and the relevant state securities laws have to be considered. Again with the speed at which Internet companies take off, it is easy to overlook the need to build a solid and fair basis on which employees can participate in the venture. With Internet start-up ventures often having employees distributed all over the country (and even the world), there is often a broader set of securities laws to consider.

Company Name and Branding - "I'm"
This issue reminds me of a famous scene in the Stanley Kubrick film, "Spartacus". It is often the case that when a new venture announces to the world "I'm Company X", a series of other companies in succession announce "No, I'm Company X". This confusion as to who is who usually stems from a failure of the new venture to properly pre-screen and then protect its company name and brands. With the advent of the Internet, this issue has taken on an added level of complexity in terms of domain names and the means by which users locate a venture's presence on the Internet (currently a "URL", which stands for Uniform Resource Locator). This has introduced a new set of voices to the traditional debate. Now as well as the exclamations of "I'm Spartacus," we also hear the cries of "Ah, but I'm"! *

The prudent thing to do when starting a new venture is to choose a company name and brand that meets your marketing goals and which is shown by comprehensive searches to be available for use. Many preliminary, screening searches can be conducted for free. For instance, the US Patent and Trademark office makes available on its Web site a free search tool for making limited searches of the federal register of trademarks and any search on one or more of the main Internet search engines will help one ascertain whether there is already someone else trading under the name you are considering. It is also essential to search on the Network Solutions Web site to determine the availability of and to reserve the desired URL (and the most obvious derivative versions of such URL). If such preliminary searches are successful, further levels of searching should be conducted to confirm the availability of the name as a trademark and corporate name, and then once an available name has been chosen, steps should be taken to reserve such name as a corporate name with the relevant Secretary of State, to register it as a federal trademark and reserve a broader range of derivative versions of the URL.

For new Internet ventures these issues are even more essential as brand recognition has proven to be one of the most bankable assets on the Internet. The costs of securing a clear trademark and domain name position will be much, much greater if protective steps are not taken until after the brand has been built. This has been illustrated by the many cases of "cybersitting" where an opportunist has launched a Web site with a URL that includes a famous brand, and then sought to hold the brand owner hostage. Also, as many Internet companies are plowing much of their available funds and equity into funding extensive advertising campaigns, it is essential that the venture's trademark and domain name position be secured to the greatest extent possible before significant dollars are devoted to such advertising.

Some New Twists

Prominence and Placements - the value of real estate on Web sites
An example of some of the unique twists that have arisen in relation to Internet start-ups is the importance and value of placements on Web sites. While there are many established practices of providing payment for endorsements or advertising space, none of those placements have the functionality, variability or characteristics of placements on Web sites. Here are some common issues associated with such placements:

  • Where does the placement go? How much prominence should it be given? New start-up ventures should focus on the terms of the agreements they reach with alliance partners and "affiliates" to ensure that there is clarity as to exactly what type of placement and prominence is to be given or received. For instance, is the placement going to be graphical and/or textual? Will it be a hypertext link to another Web site or a co-branded area? Where on the Web site will it appear? On the home page? At the top or the bottom of the page? What size will it be (usually determined in terms of number of pixels)? Clarity is often hard to reach, in part because of the technical variables involved (e.g. browser software can create different displays of the same Web page; the size of the user's monitor can determine how much of a page appears "above the fold"). One good practice is to develop prototype pages that illustrate the intended placement and then attach those pages to the contract as an example.
  • Ever evolving business plans/convergence. New start up ventures should also consider very carefully the escape clauses in any contract. Internet businesses have a habit of changing their business plans almost overnight and it may be that your alliance partner or affiliate will become your competitor. Or, through merger or acquisition, your placements may be suddenly on the Web site of company owned by your rival. Thus it is important to try to seek flexibility in any contractual arrangement, such as through rights of termination.
  • Changing value of the real estate. The placements you sell today may be worth much more in the future. So again, consider carefully your exit strategies for any placement arrangements.

Exclusives and MFN - you may need the UN
Another common set of problems that seem to be arising with an alarming regularity with new Internet ventures is the proliferation of overlapping commitments to business partners. Often, to secure a new relationship, funding or customer, a new venture will give exclusivity commitments and/or commitments not to offer more favorable commercial terms to other parties (the latter is often referred to as a "Most Favored Nation" or MFN provision). Here are some common pitfalls that new ventures often fall into:

  • Overlapping or the same exclusive. In the rush to establish new alliances or affiliations, a new venture still has to be careful not to promise the same exclusive arrangements to more than one party. Otherwise the venture will be in breach of its contractual commitment to both of the other parties. Exclusives should be carefully and concisely drawn and limited in a readily identifiable way (e.g. duration, type of content, type of customer, language). Here again there is need to be wary of convergence and business/technology evolution. As well as the convergence of the companies involved in these industries, there is also the potential convergence of the technologies involved (e.g. Internet and TV). A new venture needs to establish a central process for controlling and tracking the grant of exclusive and non-exclusive (as a non-exclusive may preclude the grant of a later exclusive) commitments and keeping good records of the venture's contracts.
  • Exclusive means you can't do it either. Another common mistake is to act on the misconception that an exclusive commitment still allows the grantor to exercise the same rights. Unless the contrary is clearly stated in the relevant contract, the usual meaning of an exclusive commitment is that it is to the exclusion of everyone else, including the grantor itself.
  • Ambiguous and escalating MFNs. Again, in the desire to move quickly, new Internet ventures are prone to committing to ill conceived and poorly drafted most favored nations provisions. These provisions can cause considerable heartburn as the venture then later tries to determine whether the MFN provision has been triggered. Also, where there are multiple MFN provisions extended by a new venture, the complications are compounded by the need to provide everyone "most favored pricing." In such situations the management of the new venture will need the diplomacy skills of an UN delegate to navigate around all the commitments that have been made. To the extent that MFNs have to be given, try to make them as narrow as possible, so that the provision only applies to completely comparable products or services, with like parameters (such as volume and price), require that the party exercising the MFN right take all the terms and conditions that the other party took as part of the comparable arrangement (e.g. the other party may have accepted less onerous warranties and indemnities) and ensure that the provision is not retroactive.

Data Privacy - build for the future now
The full importance of the data collected at Web sites and the impact of FTC vigilance and existing and potential regulation has become a major issue for any new Internet venture. One of the key issues for a new Internet venture is to educate itself on the state of play in this area and build data collection and management functions that comply with the law and build for the future. Many existing Web businesses are stuck with trying to determine how, if at all, they can use the data they have already collected without explaining to the data subjects how and why the data was collected. A new Internet venture has an opportunity to take a better approach and to build data collection and management processes that anticipate later uses for the data and ask for the data subjects' permission for such use. At a minimum, a privacy policy should be posted that provides a clear basis for users of the Web site to know how their data might be collected and used. Preferably, some means of obtaining explicit consent (for instance a "clickthrough" dialog box) should be employed. Once collected, unless the integrity of the permissioned data can be ensured, the value of the data is significantly reduced. Thus it is important to build processes that adequately allow for matching of the data with the user's permission. Also, if the new venture will have physical operating presence in foreign countries, particularly if in the European Union, there may be a need to register these data collection and processing activities and transfers of data between the EU and the US may ultimately be restricted. Thus again it is important to be informed of the legal issues, to ensure that the data collected does not become tainted. Also, there are a number of popular third party service providers that are assisting with establishing privacy policies and compliance processes which the new venture might consider using.

New Business, New Patents - the likely impact of patents for business processes
Although the recent State Street decision and the determination that business processes are appropriate subject matter for patent protection impact all potential new ventures, their impact is likely to be particularly hard felt in the Internet and e-commerce arenas. This is due in part to the fact that the Internet, by its very nature, presents a tool by which innovative new methods of doing business can be developed and deployed. There is now a heightened need for new Internet ventures to analyze the patent terrain and the potential for patent protection and infringement. Patents might be an extremely potent weapon against your competitors, if your patents cover a part of the competitor's business. The threat of litigation alone may make it difficult for your competitors to raise their own capital. If you are successful at trial you may be able to either preclude your competitor from the market altogether or command a royalty that will eat into their profits or add significantly to their losses. If in turn your venture receives a claim of patent infringement from a third party, having your own arsenal of patents may be useful in responding to such threats, as you can offer cross-licensing arrangements as a potential resolution of their claim. The key is to seek the counseling of patent counsel before disclosure of the new business process or product to others in the absence of a confidentiality agreement and promptly after the development of the business process or product. It is inevitable that the e-commerce arena is going to be a battlefield for numerous patent suits and it is advisable for new Internet ventures to come to the fight appropriately armed!

Reliance on Outsourcing - balancing the advantages against the risks of relying on others
To execute on new opportunities quickly and to avoid the costs associated with developing non-core competencies internally, all new Internet ventures outsource some if not many of their functions. This very often concerns the hosting and maintenance of the new venture's presence on the Web, which is obviously of critical importance. These arrangements are commonly referred to as "outsourcing" which is a term that can be used to describe any number of activities and relationships. The following are some of the most important legal issues associated with any information technology outsourcing relationship:

  • Control. The biggest leap of faith with any outsourcing arrangement is entrusting the due performance of the function to a third party. The new venture will need to have a contract that provides them with sufficient control over the operation and management of the outsourced function and the ability to get recourse (such as credits against fees and/or termination rights) if the outsourcer does not perform to the pre-agreed standards. The outsourcer should also agree in advance to reasonably and promptly cooperate with any request to transition to another service provider. Also, the new venture, and not the outsourcer, should own the URL for the Web site.
  • Security. The new venture will need to ensure that the outsourcer's facilities and systems are sufficiently secure so that sensitive data cannot be accessed by unauthorized persons. Also consider the need for periodic audits and setting standards for security, such as the SAS 70 accounting standards. Consider asking the outsourcer to provide covenants, warranties and indemnities in relation to such security standards.
  • Back up. The arrangement needs to provide for adequate means for ensuring that the new venture's Web site and business can be immediately restored and data loss and corruption avoided.
  • Disaster recovery. A new Internet venture needs to ensure that the outsourcing agreement includes a disaster recovery plan and that such a plan adequately protects the business (promising to have the Web site back up-and-running in 30 days may be too little, too late - the venture's users and their business may be with a rival site in a matter of days, or even hours).
  • Exit rights. As well as being a means of ensuring control, termination rights are also important commercially because of the potential need to exit from the contractual relationship to benefit from lower charges and new technologies being offered by alternative service providers.

As the above illustrates, there are many new twists on the traditional legal issues that any new venture faces, and that resolution of such issues requires an in depth understanding of the business, technology and applicable law, and a good deal of planning and preparation to ensure that the new venture has the best possible platform on which to build its business.

* Incidentally, is the Web site of a software company and is a Web site currently under construction for a multimedia company.