A Story

A Story

I am in the middle of a Rule 506 all accredited investor offering. One of the folks who wants to invest in my company was stumped at my accredited investor questionnaire.

He earns $175,000 a year. He doesn’t have a $1M net worth. He wanted to invest. I told him I was really sorry. He couldn’t invest because he isn’t accredited.

He told me he is married, and his partner Jim makes $175,000 a year. Therefore, he said, he meets the income test–because with spouse he makes more than $300,000.

I still had to tell him he couldn’t invest because of current federal law which does not recognize the validity of same sex marriages. For more information on this topic, check out startupequality.com.

Posted in Financings | 2 Comments

A Legal Primer on Websites

By Sanjay M. Nangia

A Legal Primer on Websites 

After spending months – maybe longer – crafting your company’s website, you may begin to wonder whether (1) your site is “legal”; and (2) you are sufficiently protecting your legal interests.  What now?  Below is a short primer on common legal issues you should be aware of.

Do I need a “terms of use agreement” or disclaimer?

If you have a relatively simple blog, you likely can get by with a disclaimer.  See the disclaimer on this webpage for a sample disclaimer.

But if you have a more interactive site or provide some service, you should consider a more formal terms of use agreement.  This agreement will help resolve questions such as: Who owns the content that users post?  What is the user permitted to do with information or content downloadable on the site?  Can users bring a suit in a far off country?  Is the site responsible for interactions between users? Who is responsible for harm caused to the user if the site suddenly becomes unavailable?

Accordingly, you should consider the following items for your terms of use agreement (note that there are numerous samples that are publicly available if you need guidance on specific language).

  • Establish ownership of the content created and posted by users (e.g. user retains ownership and site is provided with non-exclusive license to showcase content on site);
  • Establish ownership of content made available to users via the site (e.g. site provides non-exclusive license to user for some limited purpose);
  • Limit permitted conduct by users (e.g. no hacking; no commercial uses; guidelines for linking to your site);
  • Disclaim any warranties and representations that may be perceived by the user (e.g. no guarantee that site’s service will be uninterrupted; no guarantee that content is accurate or complete);
  • Limit the site’s liability (e.g. no liability for harm caused through use of site, transactions conducted on site, viruses/malware);
  • Provide a forum for disputes (e.g. private arbitration, which may be more cost effective than in-court litigation); and
  • Alert users as to how you handle their private information (more on this below).

Beware that users sometimes do not respond kindly to significant changes to a terms of use agreement.  For example, Instragram’s modifications to its terms of service appeared to rub some people the wrong way, and resulted in a lawsuit.  The reaction to Instagram’s changes suggests that you should get the policy right the first time.  And any modifications should be done sufficiently early in the development of your company.  If significant changes must be done later, you may consider making them in a limited, piecemeal fashion so as not to overwhelm and outrage your users.

Do I need a privacy policy?

If you are collecting personal data, either through cookies or user input, you need some form of a privacy policy.  The policy should be easy to find on the website.  References to the policy should be linked to the full text of the policy so that a user can easily find it.  Below are some considerations for a privacy policy:

  • Describe how personal information is collected and handled (e.g. type of data collected, how it is collected, why it is collected, who it is shared with, why it is shared, where data is stored, and how complaints about privacy can be addressed).
  • Provide users with information about the type of cookies being used on the site and why such information is being collected.
  • Include the option to easily opt out of any marketing emails from your site.
  • Assuming your site is not directed at children under the age of 13, affirmatively state that children under 13 are prohibited from using the site.
  • You should clarify that any links shared or provided by your site are for informational purposes only and are not managed or endorsed by you.  Accordingly, any personal data collected by those sites is not part of the privacy policy.
  • If your site is collecting financial information, sensitive personal information (e.g. social security numbers), or directed at children under age 13, those privacy issues are beyond the scope of this article.  The Small Business Administration has fairly comprehensive information about handling these situations. (http://www.sba.gov/content/privacy-law).

What’s that © at the bottom of the website? 

To help avoid any doubt that your content is copyright protected, put a copyright notice in readable font at the bottom of the page.  It should say “© Current Year. Name of Copyright Owner.”

Does the domain present any trademark infringement or cybersquatting issues?

Likely, you have done some research about your company name and attempted to steer clear of companies with similar names, or trademarks.  Yet entrepreneurs often forget that their domain name should also not create consumer confusion.  Obviously, you should avoid blatant conflicts with existing business names.  But to avoid the possibility of a nasty letter from a lawyer down the road, you should consider any perceived confusion.  For example, if you owned a food company named Mickie Daniels, you might initially consider using www.mickieds.com.  Unfortunately, consumers may confuse it with McDonald’s website.  Yes, McDonald’s uses a different domain (www.mcdonalds.com).  But because McDonald’s is sometimes referred to as “Mickie D’s” and the companies are operating in the same market, you could be asking for trouble.

Am I responsible for content posted by users or their behavior generally?

While you are generally protected from liability for content that you had no actual knowledge of, you cannot ignore the obvious.  Accordingly, you should have a procedure for other users to report complaints, especially for copyright infringement issues.  Then, you should monitor the reports and respond accordingly.  You should also create a policy for repeat offenders.

Specifically, under the Digital Millennium Copyright Act (DMCA), you must designate an agent that will receive infringement complaints from copyright owners. You must then notify the Copyright Office of the agent’s name and address and make that information publicly available on your web site.  The form is available on the government’s website (http://www.copyright.gov/onlinesp).

Posted in Uncategorized | 1 Comment

C Corps v. S Corps

s corp v c corpSuppose you’ve decided that you want to form your new business as a corporation (not an LLC), and you are trying to figure out if it should be an S Corp or a C Corp. How do you decide? Flip a coin? Arm wrestle your co-founder? Rely upon your lawyer’s or CPA’s advice? The following is a high level summary of some of the more important federal income tax and non-tax considerations involved in choosing between doing business as an entity taxed for federal income tax purposes as:

  • a C corporation (C Corp) vs.
  • an S corporation (S Corp); and

I generally don’t recommend a coin toss as the method of deciding. Hopefully, the pros and cons listed below will help you.

C CORPORATION ADVANTAGES/S CORPORATION DISADVANTAGES

  • Traditional Venture Capital Investments Can Be Made – C corporations can issue convertible preferred stock, the typical vehicle for a venture capital and angel investment. S corporations may have a single class of stock only and therefore cannot issue preferred stock.
  • Retention of Earnings/Reinvestment of Capital – Because a C corporation’s income does not flow or pass-through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxes payable on account of taxable income that passes through to them. An S corporation’s pass-through taxation may make conservation and reinvestment of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).
  • No Single Class of Stock Restriction – S corporations can only have one economic class of stock; thus, S corporations cannot issue preferred stock. This restriction can arise unexpectedly, and must be considered whenever issuing equity, including stock options or warrants. (S corporations can, by the way, issue voting and non-voting stock, as long as the stock is economically the same class.)
  • Flexibility of Ownership – C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations, in contrast, can only have 100 shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).
  • Eligibility for Qualified Small Business Stock Benefits – C corporations can issue “qualified small business stock.” S corporations cannot issue qualified small business stock, thus S corporation owners are ineligible for qualified small business stock benefits, such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock. Currently, for C corporations acquired before the end of 2013, this exclusion is 100% (subject to a generous cap).
  • More Certainty in Tax Status – A C corporation’s tax status is more certain than an S corporation’s; e.g., a C corporation does not have to file an election to obtain its tax status. S corporations must meet certain criteria to elect S corporation status; must elect S corporation status; and then not “bust” that status by violating one of the eligibility criteria.
  • Avoidance of Shareholder State Income Tax Problems – Shareholders of an S corporation may be subject to income taxes in states in which the S corporation does business.

S CORPORATION ADVANTAGES/C CORPORATION DISADVANTAGES

  • Single Level of Tax – S corporations are pass-through entities: their income is subject to only one level of tax at the shareholder level. A C corporation’s income is taxable at the corporate level and distributions of earnings and profits to shareholders (i.e., dividends) that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., the dividends are effectively taxed twice). This rule is also generally applicable on liquidation of the entity.
  • Pass-Through of Losses – Generally losses, deductions, credits and other tax benefit items pass-through to a S corporation’s shareholders and may offset other income on their individual tax returns. These returns are subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other applicable limitations. A C corporation’s losses do not pass through to its shareholders.

 

Posted in Business Entities | Tagged , , , | 2 Comments

Taxation of Social Purpose Corporations

Question:

I received the following question from a CPA friend the other day:

“I have a client that recently formed a Washington social purpose corporation. Do you have a sense of how SPCs are characterized for federal income tax purposes?”

Answer:

For tax purposes, Washington social purpose corporations are just a type of Washington for profit corporation, formed under the Washington Business Corporation Act, RCW 23B. There is no difference in federal or state tax treatment between an SPC and a regular for-profit corporation.

Accordingly, for federal tax purposes, SPCs are generally treated as ordinary C corporations, which are subject to corporate income tax. If they have only one class of stock and fewer than 100 shareholders, and otherwise qualify, they may elect to be classified as S corporations, which pass gross income, deductions, and losses through to shareholders.

SPCs, like other corporations, can’t be classified as partnerships. Similarly, because SPCs may distribute earnings to shareholders and use assets for shareholders’ benefit, they can’t generally qualify for tax-exempt status (such as Section 501(c)(3) or 501(c)(4) status).

For Washington State tax purposes, SPCs are taxed just like any other type of business entity. They are subject to the business and occupation tax, regardless of whether they are considered C corporations or S corporations for federal tax purposes; Washington does not recognize pass-through companies. They are also liable for sales tax on both sales and purchases, as well as property taxes, in the same manner as other Washington businesses.

Posted in Social Purpose Corporations, Uncategorized | 3 Comments

Venture Capital Fund

Flowchart for Exemption Under the Investment Advisers Act of 1940

By Joe Wallin and Asher Bearman

This article is appearing simultaneously on The Venture Alley and on Startup Law Blog

The below flowchart may be helpful to you in answering the question whether you qualify for the exemption for “venture capital funds” under Section 203(l) of the Investment Adviser’s Act of 1940 ( the “Advisers Act”), pursuant to the final rules promulgated by the SEC.1  In all cases you should consult with an attorney.  For more detailed information regarding the federal exemption, check here.  Note that the Washington State Department of Financial Institutions (DFI) has proposed rules that are going to require many fund managers to register with the State as investment advisors.  We plan to prepare a separate flowchart to help you understand those rules once they are finalized.
Venture Capital Fund

(i) http://www.theventurealley.com/vc-and-pe-funds/private-fund-adviser-exemption-150m-from-registration-under-the-advisers-act-final-dodd-frank-act-ru/

(ii) http://www.theventurealley.com/vc-and-pe-funds/reporting-requirements-for-funds-exempted-from-investment-advisers-act/

(iii) http://www.theventurealley.com/vc-and-pe-funds/washington-state-to-regulate-fund-managers/

1 Here is the full text of Section 203(l):  “EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.—No investment adviser that acts as an investment adviser solely to 1 or more venture capital funds shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund. Not later than 1 year after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘‘venture capital fund’’ for purposes of this subsection. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.”

2 “Investment adviser” means, generally, any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.

3 “Qualifying investments” means (i) an “equity security” issued by a “qualifying portfolio company” that has been acquired directly by the private fund from the “qualifying portfolio company;” (ii) any equity security issued by the qualifying portfolio company in exchange for an equity security issued by the qualifying portfolio company described in section (i) above; or (iii) any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, as defined in section 2(a)(24) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(24)), or a predecessor, and is acquired by the private fund in exchange for an equity security described in sections (i) or (ii) above.

4 “Qualifying portfolio company” means any company that: (i) at the time of any investment by the private fund, is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded; (ii) does not borrow or issue debt obligations in connection with the private fund’s investment in such company and distribute to the private fund the proceeds of such borrowing or issuance in exchange for the private fund’s investment; and (iii) is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by Section 270.3a-7, or a commodity pool.

5 “Equity security” means any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security.

6 An exempt reporting adviser is an adviser that has to make public filing of certain information, despite being exempt from registration.  For example, here is the exempt reporting adviser Form ADV for Union Square Ventures.

 

Posted in Federal Law & Regulation | Tagged , , , | Comments Off on Venture Capital Fund