Alternatives To Equity Compensation

Equity compensation is a well known tool for rewarding and incentivizing teams. But it is not for everyone.

Many founders are either unable or unwilling to share ownership of their company but still want to offer their team upside potential in the business.

In this scenario, it’s often possible to create a deferred compensation program that mirrors some of the economic benefits of ownership without actually issuing shares.

Examples:

Transaction Bonus Plans. Companies can grant service providers rights to a share in the proceeds of a liquidity event, such as a Company sale.

Profit Sharing Plans. Companies can grant service providers rights to share in the Company’s annual profits.

Phantom Stock Plans. Companies can grant service providers “phantom stock” which appreciates in value alongside actual stock and can be liquidated in connection with certain future events, such as retirement or a change of control.

As with stock grants, participation in these programs can be made subject to vesting, the achievement of milestones, or other requirements.

These programs have drawbacks and aren't perfect. Payments are generally taxed as ordinary income rather than capital gains. And they must be structured carefully to comply with stringent tax requirements, including IRC 409a.

Nevertheless, they are valuable and useful tools for founders seeking to reward and incentive long-term team members while retaining full ownership and control of their companies.

When should I incorporate my startup?

Often founders are unsure if it makes sense to spend the time and money to incorporate their venture.

This is a legitimate issue.

In my experience, early stage ideas can take time to ripen.

Often, in the earliest stages, the future of a project or idea is still murky.

There is some potential for a business but questions remain unanswered.

Perhaps there’s a potential product but it’s not clear if it will be economically viable or meet consumer needs.

Or the project may have some traction but it’s not clear if it can generate revenues.

More research, tinkering and experimenting may be required.

In circumstances like this, the expense and formality of a corporate form may be unnecessary.

It can make more sense to let the project incubate and evolve until it is more clear what it wants to become.

Ripeness arrives when the Founders have achieved enough clarity that they are prepared to invest meaningful time, money or other resources into the business. They are ready to hit the gas pedal.

This isn’t always the case, particularly where the tinkering and experimenting involves a lot of money or multiple founders or activities with high legal risks.

For example, a team of founders who are investment in a bunch of money to R&D a medical device would want those relationships and investments fully documented.

Whereas a solo founder with a side software project may choose to focus resources on product development. That founder might use a basic pre-incorporation agreement to get on the same page with team members while they incubate the idea. Then, once it’s clear the software meets a real need and can attract paying users, they pull the trigger.

At that point, forming an entity will enable the founders to raise money from investors, hire a team with equity, enter into contracts with enterprise or consumer users, and so forth.

As the project grows and expands, more people are impacted and thus more risk is generated. Incorporation enables founders to assume those risks without putting their personal assets at risk.

Another way to think of this question is: what are the benefits that become available to me once I incorporate and when can I really take advantage of them? Again, the answer for the most part is when the business idea has become fairly well crystalized and founders are ready to start accelerating their efforts with investments of time and/or money.

I feel called here to add a typical lawyer caveat: every situation is unique. Corporate entities provide personal liability protection. The wealthier you are, the less it makes sense to wait and the more it makes sense to do anything potentially business-related through a corporate entity.

Can a startup raise money from non-accredited investors?

Entrepreneurs are often advised to raise money from accredited (i.e., wealthy) investors only only.

It's true that limiting an offering to AIs poses fewer regulatory burdens and probably fewer risks. And many institutional investors prefer to see cap tables without AIs.

But not all founders have access to a pool of wealthy investors.

In those cases, the bias against non-AIs can keep founders stuck and unable to access needed capital they need to grow their business.

Securities laws do require more investor protections when raising money from non-AIs - and for good reason. It’s important to understand and comply fully with those requirements.

But they are not as daunting (or expensive) as conventional wisdom says.

The bottom line for entrepreneurs is this:

It is 100% possible to raise capital from non-accredited investors in an ethical manner and in full compliance with all relevant securities laws.

We do it all the time.

Are there tax advantages to organizing as a benefit corporation?

I’m sometimes asked whether benefit corporations enjoy particular tax benefits relative to other for-profit corporations.

The answer is no.

Benefit corporations are taxed identically to other for-profit corporations.

As such, they can be taxed as s- or a c-corporations and will be subject to the same tax rates, requirements and regulations.

Although benefit corporations are required to promote general public benefit, they do not enjoy the tax breaks bestowed on tax-exempt charitable organizations like 501(c)(3) non-profits.

Some localities are experimenting with local tax benefits to promote benefit corporations and other sustainable businesses. See this article for an example.

But as of this writing, there are no federal or (as far as I know) state-level tax benefits conferred on benefit corporations.

There are many good reasons to organize as a benefit corporation but tax law is not one of them - at least not as of now.

How To Convert Your Company Into A Benefit Corporation

Benefit corporations enable founders to create an aligned, mission-driven legal structure for their venture.

We are regularly asked to convert existing companies into California benefit corporations or Delaware public benefit corporations.

This post provides a high-level summary of the process.

Specific conversion requirements will vary depending on the entity and jurisdiction in question. But the following basic framework will apply across the board.

For convenience, I refer to both benefit corporations and PBCs as “benefit corps” in this article.

1 - Determine What Shareholder and Director Approvals Are Necessary.

Conversion into a benefit corp will require the approval of your shareholders and board of directors.

The specific threshold voting requirement depends on your state of incorporation and internal shareholder agreements. For example, conversion of a California entity into a California benefit corporation will require a 2/3 vote of each outstanding class or series of shares, whereas conversion of a Delaware corporation into a Delaware PBC will not have a supermajority voting requirement.

Once you’ve confirmed shareholder and director voting requirements, you should assess whether sufficient support exists for the conversion and what actions may be required to achieve the required consensus.

2 - Determine Whether The Approval Of Other Parties Is Required.

Credit agreements, investment agreements, shareholder agreements and other material corporate documents commonly contain provisions requiring prior approval to any amendment to the company’s certificate of incorporation or other material corporate changes. Accordingly, it’s important to confirm whether other parties, especially lenders and/or outside equity investors, may have the right to be notified of and/or approve the conversion. If so, you’ll need to develop a plan for providing the required notice and securing the required consent.

3. Draft a new Certificate of Incorporation and other required legal documentation.

Once you’re reasonably assured of having the required approvals, you’ll want to engage your corporate lawyer to prepare the necessary legal documentation.

It’s at this stage that you’ll have the opportunity to embed your company’s mission into the legal fabric of its corporate governance and leverage the benefit corp form to reflect their values and vision. You’ll also need to determine certain specifics around your benefit governance, such as the mechanics of benefit reporting, matters relating to director indemnification, the use of third party standards (like Certified B Corp), and the like.

For intra-state conversions (e.g., California corp into a California benefit corp), the conversion mechanism is an amendment to your articles of incorporation. Other conversions (for example, California or other LLCs into California benefit corps, California corps into Delaware PBCs) the required documentation will be more involved.

4. Conduct Required Shareholder and Director Votes.

With formal legal documentation in hand, you’ll be in a position to conduct form votes (or obtain formal written consents) approving the conversion and attendant legal documentation.

5. File Your New Corporate Charter.

Once your legal docs are approved, they can be filed with your Secretary of State. This step completes the formal conversion of the entity into a benefit corporation.

6. Print and Issue New Stock Certificates.

Delaware, California and other benefit corp jurisdictions require stock certificates to contain clear notices that the corporation issuing the shares is a benefit corporation. It’s accordingly advisable to issue new stock certificates or if your stock is not certificated, new notices to shareholders to reflect the change to benefit corp status.

7. Name Changes.

If your company has changed its name in connection with conversion, those changes should be implemented across the company’s accounts (e.g. bank accounts, vendor accounts, etc.) in a reasonable time frame.

Summary

In general, the process of conversion is a fairly straightforward, particularly for smaller companies with simple cap tables and balance sheets. As companies mature, a wider range of considerations and stakeholders come into play and so the process tends to be more involved. The above overview should provide a general sense of where your company falls on that spectrum.

Hat tip to Frederick Alexander, whose excellent book Benefit Corporation Law and Governance served as a helpful reference for this post.

Pre-Seed and Series Seed Financing Data for Q2 2020

WSGR has just published its H1 2020 Entrepreneur Report (link below), it contains some interesting data points with regard to Q2 2020 financings. Some highlights:

• Q2 VC market strong by historical standards

• Median amount raised and valuations up significantly

• Median Pre-Money Valuation @ Series Seed: $12 million

• Median Amount Raised @ Series Seed: $2.8 million

Data points for pre-seed bridge financings --

• Median Amount Raised: $830,000

• Maturity date: 12 months+

• Interest rate: <8%

• Discount: 80% of deals, vast majority at 20%+

• Cap: 64% of deals

Median Cap: $8 million (down from $9 million in 2019)

More info on Series A and later financings, plus a cool interview with Benedict Evans, in the Report, which you find here.

SEC (Barely) Expands The Definition of Accredited Investor

Most private stock offerings are limited to "accredited investors", i.e., wealthy people and entities.

This limit is designed to protect the vulnerable from unscrupulous business practices.

(There are important and IMO under-utilized exceptions but that's a story for another post.)

The AI rule, which dominates private capital raising, can be very frustrating for both entrepreneurs (who want access to more investors) and investors (who don't want to be blocked from good investment opportunities).

For years, many have clamored for a more targeted approach to expand the capital base without compromising investor protections.

Last week, the SEC took the first modest step in that direction in decades.

Specifically, the SEC provided a pathway based on training and professional certification (rather than wealth) for individuals to qualify as an AI.

For now, only people with Series 7, 65, and 82 licenses qualify.

On a go-forward basis, we can expect other certifications to emerge that open the door to AI status.

Not an immediate game changer -- but a prudent and sensible step in the right direction. Would love to see more in this direction.

More from the SEC here: https://www.sec.gov/news/press-release/2020-191

A Potential Silver Lining to Lower Covid Valuations: Equity Grants

Covid sucks, but for the sake of optimism, here's something to consider.

Lower business valuations make equity grants more feasible and advantageous from a tax standpoint.

Here's how.

Equity granted in exchange for services is taxable based on the fair market value of the shares or LLC interests.

So if your business is valued at $5 million, and you grant 10% in equity to a new team member, that team member will have to report $500,000 in ordinary income on their tax return and fork over roughly $200,000 in cold hard cash to pay income taxes.

On top of that, the company will owe employment taxes on the grant value.

It's an unfortunate tax rule that promotes inequity, and there is grumbling to change it. But for now, it’s the law of the land.

Stock options and LLC "profits interests" solve the tax issue — but at significant expense to the recipient of equity.

In example above, the recipient would receive options rather than stock and would then have to pay a $500,000 "exercise price" to buy the shares they've been granted.

Of course, option recipients will not exercise until the company's stock has appreciated, typically in connection with an exit. But in the meantime, the capital gains tax clock is not running and they have none of the rights of a stockholder. And if the recipient leaves prior to a liquidity event, they need to somehow come up with the exercise price (often within 90 days) or risk forfeiting their options.

LLC profits interests have fewer of these drawbacks but the recipient still must forego $500,000 in value to avoid taxation upon grant. Again, not ideal.

When a company's valuation is low, stock and LLC interests can be granted with reduced tax and other burdens. Equity recipients have the potential to retain more of the benefit of the equity grant, enhancing both the economic value and incentivizing impact of the grant.

So bottom line - if you have been considering equity grants, now might be a good time to make it happen. A revised company valuation for equity grant purposes can be done quite cheaply these days, and having a fully-incentivized team in place as we turn the Covid corner might make a big difference.

Implementing Personal Leaves of Absence and Sabbaticals Into Partnership Agreements

Recently, we completed a partnership agreement where the partners built in a framework for taking creative and personal sabbaticals without being in a breach of their partnership obligations.

They're both committed substantially full-time to their partnership. But they also wanted some flexibility to take deep dives into outside creative and personal pursuits, so long as the company would be okay.

So we built some parameters and procedures into their partnership agreement enabling them to take these leaves while ensuring their company and partner are protected.

I love the approach.

What I've found in my career is that having the freedom and capacity to pursue the full scope of my creative interests enables me to bring much more of myself to work.

And having the autonomy to determine when and how much to do that has been a huge source of fulfillment.

So kudos to my clients here. I think they've done something to make their partnership a lot more productive, inspiring and resilient.

The Value of Startup Advisory Boards

Many of our most successful startup clients use advisory boards to powerful effect, especially in the earlier stages when cash is short.

In those early days, building a team of advisors with equity can help a company in many many ways.

Advisors bring new ideas and expertise into the mix.

They can open up new sales or distribution channels.

They can make introductions to key prospective clients or partners.

They can help get large projects out the door without burning too much cash.

They can help improve your product and get to product market fit faster, as this Techcrunch article suggests.

Most important, I think, they help build energy, momentum and community around a company at a time when founders need it most.

Pulling an advisory board together also helps entrepreneurs hone a key skill - enrolling others to support the vision.

It's a tool and a tactic that's well worth considering where appropriate.

Reviewing Your Contracts In Response To Covid-19

As we all deal with the fallout of the Covid19 pandemic, businesses may need to review and evaluate their existing contracts to assess relevant rights, remedies and/or obligations that may come into play in the coming days and weeks.

Following are contracts and provisions that may require attention. For the time being, we’re offering contract review and consult on a complimentary basis to help our clients and community weather this storm. Please email me here to set one up.

Commercial Agreements.

• Force Majeure- Are your contractual obligations excused due to an act of Force Majeure? Does the current pandemic rise to the level of an act of force majeure under your contracts? How long does the Force Majeure need to last under the agreement?

• Are there notice requirements which you may need to give or receive?

• Is there a termination right as a result of the pandemic, either by you or the other party?

• What are the consequences of a breach or default?

• Who is responsible for a break in a supply chain agreement?

Commercial Lease Agreements

• Does a force majeure provision excuse payment of rent or delays in performance?

• Does business closure prevent lease performance by landlord or tenant?

• What provisions may impact a request for rent deferral?

Financing Agreements may be impacted as well in a variety of ways, including

• Financial Covenants - are you able to meet your payment obligations and maintain financial ratios / covenants under your credit facilities.

• Material adverse events- Does this situation rise to the level of MAE and if so, what actions are triggered as a result?

• What representations and warranties have you given or received may be affected by the pandemic?

Employment Agreements. What are your obligations under employment agreements with respect to leave or severance pay?

Insurance Policies. Do your policies offer coverage for business interruptions or closures?

M&A Agreements. Are there indemnity provisions, reps and warranties, and/or financial or other covenants that may be triggered by the Covid-19 outbreak and resulting economic impacts?

Stockholder or Investor Agreements. Do your governance-related documents contain notice, Board-related or other voting provisions that may be triggered?

These are unprecedented times and events. I know we’ll get through it. Let’s do it together.

New Employment Laws in California

2020 is underway, and with a host of new employment laws in California. The most prominent, AB5, narrows the rules for classifying workers as independent contractors and has had broad impact for companies doing business in the state across numerous industries.

Other new laws have more limited impact, but still require affirmative action on the part of companies to ensure they’re up-to-date on the new rules. Here’s a brief overview of the key employment law changes for 2020.

The ABC Test & Independent Contractors

The new legislation—aimed squarely at the gig economy—adopts the California Supreme Court’s opinion in Dynamex Operations West, Inc. v. Superior Court, a 2018 case that began this shift in worker classification. The Court’s “ABC test” requires that an employer establish three factors to justify an independent contractor classification:  

1. the worker is free from control and direction over the performance of the work, both under the contract and in fact;

2. the work provided is outside the usual course of the business for which the work is performed; and

3. the worker is customarily engaged in an independently established trade, occupation or business (hence the ABC standard).

You can read our full summary of the new AB5 framework here.

Prohibition Against Arbitration Agreements On Hold - For Now

Under AB51, employers can no longer require arbitration as a condition of employment (new or continued) in Fair Employment and Housing Act and labor code claims in their agreements with job applicants, employees, and independent contractors. This applies to requirements for arbitration related to employment benefits as well.

But the validity of AB51 is still unclear. On February 7, 2020, Chief U.S. District Judge Kimberly Mueller of the Eastern District of California granted a preliminary injunction enjoining enforcement of the new measure. Judge Mueller wrote that the plaintiffs challenging the new law satisfied their burden of showing that AB51 was likely preempted by the Federal Arbitration Act and they were likely to succeed on the merits of their claim. Mueller also wrote that AB51 interfered with the FAA given the civil and criminal sanctions imposed on employers for violating the law.

The State will likely appeal the ruling, taking the case to the Ninth Circuit.

“No Rehire” Provisions in Settlement Agreements

AB 749 prohibits “No Rehire” provisions in settlement agreements. These were common clauses that would prohibit a former employee from applying for a job with that company again, anywhere in the country.

Under the new law, settlement agreements cannot include any provision that prohibits, prevents, or otherwise restricts an employee from working with that employer (or any of its affiliated entities) again in the future.

New Labor Provisions for Nursing Mothers

SB142 includes new provisions regarding required lactation accommodations for employees. Employers must:

• Provide a lactation room or location that includes access to a sink and refrigerator in close proximity to the employee’s workspace

• Provide employees with reasonable break times or adequate space to express milk

• Refrain from discharging, or in any other manner discriminating or retaliating against, an employee for exercising or attempting to exercise rights under SB142

Companies with fewer than 50 employees may seek an exemption from the requirements if they can demonstrates that the requirement poses an undue hardship. But exempt employers must still make a reasonable effort to provide a place for an employee to express milk in private.

Protected Hairstyles under the Fair Employment and Housing Act

SB188 updates the definition of “race” under the California FEHA to include “traits historically associated with race, including, but not limited to, hair texture and protective hairstyles.” Under the updated definition, protected hairstyles include “braids, locks, and twists.”

This update comes as black hair came under the Oscar spotlight. Former NFL receiver and current film director and producer Matthew Cherry won an Oscar for Best Animated Short for Hair Love, a story about a black father who learns to do his daughter’s hair. He said that "Hair Love was born out of wanting to see more representation in animation but also wanting to normalize black hair."

Disclaimer

Please note the foregoing is not intended to be an exhaustive summary of new employment laws and changes in California or the steps to be taken to become compliant and is not intended as legal advice.  For customized recommendations and guidance concerning your independent contractor relationships, please contact us directly.

Complying with California's New Consumer Privacy Act

The California Consumer Privacy Act of 2018 (“CCPA”) went into effect on January 1, 2020.  CCPA was passed quickly by the California Legislature in the wake of the Facebook/Cambridge Analytica revelations, the General Data Protection Regulation (“GDPR”) in Europe, and a proposed California ballot initiative that would have been much more difficult to amend.  CCPA

The CCPA applies to for-profit entities that do business in California and either (i) generates annual gross revenue in excess of $25 million; or (b) receives or shares personal information of more than 50,000 California consumers; or (c) derives at least 50 percent of its annual revenue from selling the personal information of California consumers. A “California consumer” for purposes of the CCPA is a natural person (not a corporation) who is a California resident, whether the individual is currently inside or outside of California. 

Even if your business has taken steps to comply with GDPR, the CCPA imposes additional obligations and responsibilities and provides new rights for California consumers.  These new requirements require immediate action in light of the law’s effectiveness. .

  The Attorney General is currently reviewing regulations to enforce the CCPA.  The regulations are not yet final.  Enforcement of the CCPA is expected to begin July 1, 2020, giving entities who have not yet complied some time to catch up. 

The following is a brief summary of the law’s key provisions and steps that affected businesses should consider taking in consultation with legal counsel.

EXPANDED RIGHTS OF CALIFORNIA CONSUMERS UNDER THE CCPA

Under the CCPA, California consumers have been given a broad set of rights with respect to the collection and sale of their personal information:

• The right to know the categories of personal information a business has collected about that consumer;

• The right to know the categories of sources from which the personal information is collected;

• The right to know the business or commercial purpose for collecting or selling personal information;

• The right to know the categories of third parties with whom the business shares personal information;

• The right to access the information which has been collected and used during the twelve months preceding the request;

• The right to have the information deleted (subject to certain exceptions); 

• The right to opt-out of the sale of personal information;

• For consumers between the ages of 13 and 16, the affirmative obligation to obtain an opt-in for the use and sale of personal information and parental opt-in for those under age 13; and

• The right to be protected against discrimination in price and quality of goods for exercising the rights under the CCPA.   (Note: This provision means that a consumer cannot be denied goods or services or charged a higher price if the consumer exercises their privacy rights.  However, the CCPA also allows your business to charge different prices or provide different levels of service “if the difference is reasonably related to value provided by the consumer’s data.”  Companies should, therefore, proceed with caution and in close consultation with legal counsel when implementing differential pricing or offerings based upon the collection of personal information.)

EXPANDED DEFINITION OF PERSONAL INFORMATION

Under the CCPA, personal information “means information that identifies, relates to, describes, is capable of being associated with, or could reasonably be linked, directly or indirectly, with a particular consumer, household or device.”  This definition of “personal information” under the CCPA is broader than the definition of personal data under the GDPR because it includes information that can be linked to a household or device as opposed to an individual consumer. 

The list of items that constitute personal information goes beyond names, addresses and Social Security numbers and includes IP addresses, on-line identifiers, geolocation data, internet or electronic network activity information such as search history and even inferences drawn from that information used to create a consumer preference profile. 

EXPANDED REMEDIES IN THE EVENT OF SECURITY BREACHES

California’s former privacy law, the California Online Privacy Protection Act, allowed the Attorney General to bring enforcement actions and seek monetary damages of $2,500 per user per violation of that act.  CCPA increases monetary damages in cases of intentional violations of the CCPA to $7,500 per violation.

The other major new development under CCPA is a private right of action for security breaches.  Under the CCPA, any California resident whose unencrypted or unredacted personal information has been exposed due to a failure to maintain appropriate security can bring an action against the business.  Damages may range from $100 to $750 per violation.  A class action is possible if enough plaintiffs wish to aggregate their claims.   Although there are procedural steps that a plaintiff would have to go through before bringing an action, failure to adequately secure personal information under CCPA may result in significant liability for California businesses.

WHAT STEPS SHOULD YOUR BUSINESS TAKE?

In light of the significant risks associated with the CCPA, growth companies engaging California consumers, including those not yet subject to the CCPA, will need to carefully plan for, establish and maintain safeguards, policies, and procedures to ensure compliance with the CCPA and related laws.  

Following are actions that businesses should consider taking in consultation with privacy counsel:

• Determine How the CCPA Applies to Your Organization.  The CCPA imposes different obligations on organizations depending on whether an organization is “selling” personal information, is acting as a “service provider” or is a third party.

• Review and Update Your Privacy Policy.  The CCPA requires increased privacy disclosures at or before the point of collection to consumers to explain the categories of data to be collected and the purpose for which the categories of information will be used. These disclosures must be updated every 12 months. 

• Review and update your Cookie Policy.  The CCPA also applies to cookies placed on a user’s computer.  Personal information about a consumer may be collected as a result of cookie placement and consumers must be given information about the use of cookies as well as the opportunity to opt-out of cookies;

• Review and Update Your Website.  In addition to a link to your privacy policy, the CCPA mandates that your business provide a “reasonably accessible and clear and conspicuous link” to the consumer’s opt-out right on your website’s homepage.  This link must be entitled “Do Not Sell My Personal Information.”  Under this portion of your website, you must explain to the consumer that they have the right to opt-out of the sale of their personal information and provide them with the means to do so (which could include the use of  an “opt-out button”.) This link also must provide certain other required information about their privacy rights;

• Review and Update your Terms of Use.  Your on-line Terms of Use often incorporate your Privacy Policy and set forth the terms and conditions on which your business provides its services.  The Terms of Use may also need to be revised to ensure compliance with the CCPA.

• Provide At Least Two Mechanisms for Consumers to Submit Requests.  You must provide, at a minimum, a toll-free telephone number for consumers to call to submit their requests for information under CCPA.  You may also include an email address, business mailing address or web form.

• Establish Consumer Information Request Response Procedures.  Your business must respond within 45 days to verifiable consumer requests for information and provide the requested information free of charge not more than twice in a twelve-month period.   You must develop a standard procedure to review, analyze and respond to consumer access requests;

• Establish Data Mapping and Collection Tracking Procedures.  You must put processes in place to map and track the information your business collects so that you can timely respond to requests for information and opt-out requests.  As stated above, the look-back period for an access request is 12 months. Many companies who have invested in developing IT infrastructure to track data collection and consumer requests in order to comply with GDPR will also need to develop mechanisms to track to comply with the CCPA.   If you did not need to worry about GDPR, you may need to worry about the CCPA and put those processes into place now.

• Train Your Team.  Your team is an important part of the compliance effort.  The new law requires that your team be familiar with the new requirements so that personal information and relevant consumer inquiries are handled quickly and properly.

• Update your Vendor Contracts.  Under the CCPA you are responsible for ensuring your third party vendors are in compliance.  Data processing addendum similar to those implemented for GDPR may be required.

Our firm has experienced privacy counsel (with both the CIPP/US and CIPP/E certification from the International Association of Privacy Professionals, the largest and most comprehensive global information privacy community) to assist in your compliance efforts and provide advice and recommendations for complying with the CCPA as well as other applicable data privacy and security laws.  Please contact us if we can help.

DISCLAIMER

Please note the foregoing is not intended to be an exhaustive summary of the CCPA or the steps to be taken to become compliant and is not intended as legal advice.  For customized recommendations and guidance concerning your California Consumer Privacy Act compliance, please contact us directly.

The Definitive Guide to Finding a Cofounder

One of the most common questions for an early-stage founder asks is “should I have a cofounder?” And the follow-up is close on its heels: “how do I find one?” So much of the decision-making process in the early stages is part art and part science, and it’s no different here. And the process is critical.

The right partnership is one of the most powerful forces for growth and success -- according to First Round, partners outperform solo founders by 163%. And Startup Genome found that startups with multiple founders will raise 30% more capital and grow customers three times as fast as solo founders.

In contrast, cofounder conflict can doom a company before it even starts. Noam Wasserman found that two out of three startups fail due to cofounder conflict. These statistics underscore just how critical the human dimension is for a new company.

Here are some of the best resources for thinking about partnership and finding a potential cofounder.

Cofounder Matchmaking

• CoFoundersLab. With a network of 400,000 members and algorithms to recommend potential cofounder candidates, CoFoundersLab is a way for entrepreneurs to reach beyond their personal networks to find potential partners.

• Founder2Be. Founder2Be has a network of more than 95,000 people, offering entrepreneurs another pool of talent to find potential partners.

• Founders Nation. Founders Nation is a UK-based platform for entrepreneurs and founders to match with potential partners. Founders Nation is active primarily in London, NYC, and Tel Aviv. 

• Lunchclub. Lunchclub is a new startup that’s fresh of a $4 million round led by a16z. Its mission is to make relevant one-on-one introductions to people through the platform. The waitlist is long right now. But the queue moves by the thousands every week as the platform expands. Lunchclub is available in London, Los Angeles, New York, and San Francisco. Oh, and by the way, Lunchclub has three co-founders.

• Meetup. This online community organizing tool has more than 35 million members worldwide. It’s a valuable platform for finding communities and connections in numerous groups for entrepreneurs and founders.

• Startbee. Startbee is a new cofounder matchmaking platform that focuses on the individuals’ skillsets as it makes potential matches.

Entrepreneur Communities & Events

A bevy of in-person and digital communities exist to serve as resources for entrepreneurs to meet, network, and collaborate together. Some of them include:

• BuiltIn. Built In is a digital platform that “unites companies and people around their shared passion for tech and the universal need for purpose.” BuiltIn holds regular events for tech talent to gather together in Austin, Boston, Chicago, Denver, LA, NYC, SF, and Seattle.

• Founder Institute. FI’s Equity Collective connects founders to a network of mentors, entrepreneurs, and investors.

• General Assembly. General Assembly provides experiential education in today’s most in-demand skills like web development, data, and design. It also boasts a network of 40,000 alumni across the globe.

• South Park Commons. South Park Commons is a collective of entrepreneurs in the Bay Area who come together to learn, explore ideas, and support each other in starting new ventures.

• Startup Digest. TechStars that curates startup-related events in cities across the globe.

• Startup Weekend. Sponsored by Google and TechStars, Startup Weekend produces three-day, in-person events across the United States to bring entrepreneurs together to find opportunities to join forces on new companies.

Online Learning Communities

• The Akimbo Workshops. Seth Godin’s name is synonymous with digital marketing, and his Akimbo Workshops offer several online learning communities where education and connection are front and center.

• Venture Deals. TechStars and Kauffman Fellows free Venture Deals e-course, based on the book by Brad Feld and Jason A. Mendelson, pairs participants in small groups to facilitate new connections with other entrepreneurs across the country.

Other Resources to Help You Approach Your Cofounder Search Process

• Essential Cofounder Conversations. We put this e-book together to provide founders with questions to spark conversations with potential partners. These conversations can help you determine if it makes sense to join forces on a common mission.

• First Round Capital’s Founder Dating Playbook (First Round)

• How to Find a Co-Founder (Guy Kawasaki)

• How To Find a Technical Cofounder, CTO or Tech Partner For a Startup (The Startup)

• How to Find and Choose the Right Co-Founder for Your Startup (Crunchbase)

• The Inspiring Stories of 10 Famous Co-Founders (HubSpot)

• Using the Business Model Canvas to Find a Cofounder (First Round)

California Enacts New Law Limiting Use of Independent Contractors

California Governor Gavin Newsom signed Assembly Bill 5 into law in September, which establishes a new approach to the use of independent contractors in business.

 Newsom wrote that AB5 “will help reduce worker misclassification — workers being wrongly classified as ‘independent contractors’ rather than employees, which erodes basic worker protections like the minimum wage, paid sick days and health insurance benefits.”

The Bill, which received strong support in Sacramento, has vocal opposition from many companies like Uber, Lyft, and DoorDash that utilize independent contractors for their on-demand services.  However, the law impact extends far beyond the gig economy and is likely to affect virtually all businesses in California. 

Codifying the Dynamex “ABC Test”

The new legislation adopts the California Supreme Court’s opinion in Dynamex Operations West, Inc. v. Superior Court, The Court’s “ABC test” requires that an employer establish three factors to justify an independent contractor classification:  

1. the worker is free from control and direction over the performance of the work, both under the contract and in fact;

2. the work provided is outside the usual course of the business for which the work is performed; and

3. the worker is customarily engaged in an independently established trade, occupation or business (hence the ABC standard).

If someone is classified as an employee, they are entitled to protections such as minimum wage,  workers’ compensation if injured on the job, unemployment insurance, and paid leave. Misclassifying an employee as an independent contractor can result in fees and penalties, back taxes and other forms of liability.

Exemptions Under AB5

The new law includes exemptions to the test for certain fields and certain relationships, including the following professions: licensed insurance agents, certain licensed health care professionals, registered securities broker-dealers or investment advisers, direct sales salespersons, real estate licensees, commercial fishermen, workers providing licensed barber or cosmetology services, and others performing work under a contract for professional services, with another business entity, or pursuant to a subcontract in the construction industry. 

If an exemption applies, the old “Borello test” will apply, which focuses on whether a company has “control or the right to control the worker both as to the work done and the manner and means in which it is performed.”

Under AB5, “professional services” includes a wide range of services including marketing, human resources administration, travel agent services; graphic design; freelance writing, photography, and many others.

Finally, the bill includes additional miscellaneous exemptions that include real estate licensees, people in the construction industry, and individuals who operate as a sole proprietorship in a “business to business” relationship.

Next Steps

Many startups and emerging companies utilize independent contractors as they build prototypes, MVPs, and assemble a core team while getting the company off the ground. Now is the time for companies to review their independent contractor relationships to determine whether the can show that the law’s “ABC test” applies or if an exemption is valid, triggering the “Borello test.”  Please contact us to learn more. 

Additional Resources

• The full text of Assembly Bill No. 5

• Guidance on independent contractor versus employee from the California Department of Industrial Relations

• Governor Newsom’s Signing Statement

• From the Los Angeles Times: Newsom signs bill rewriting California employment law, limiting use of independent contractors

Disclaimer

Please note the foregoing is not intended to be an exhaustive summary of AB5 or the steps to be taken to become compliant and is not intended as legal advice.  For customized recommendations and guidance concerning your independent contractor relationships, please contact us directly.

Delaware Affirms Key Oversight Function of Directors in Highly Regulated Industries

In an opinion issued this summer, the Delaware Supreme Court recently affirmed that corporate directors in highly-regulated industries must exercise adequate oversight over safety and compliance matters as part of their fiduciary duties of care and loyalty. 

The decision presents an opportunity for food and drug makers and others whose products raise safety concerns to review their corporate governance practices to improve oversight, enhance safety, and protect management from legal exposure. 

Background of the Case

The case, Marchand v. Barnhill, involved shareholders’ claims against Blue Bell, the fourth-largest ice cream maker in the country, whose products were contaminated by a listeria outbreak in 2015, causing  three deaths and a massive product recall. 

As a result of the outbreak, Blue Bell laid off one-third of its workforce and was forced to accept a highly-dilutive capital infusion to keep operations going. 

The court’s legal opinion focused on two issues: first, whether directors holding a majority of the board’s votes could impartially consider the shareholder’s claims that management breached its duties in connection with the outbreak; and second, whether the board of directors breached its fiduciary duties by failing to adequately oversee the safety of Blue Bell’s food-making operations.

As the court noted in its opinion, Blue Bell operated as a single-product food manufacturer, and “food safety was essential and mission critical.” The company was “required to comply with regulations and establish controls to monitor for, avoid and remediate contamination and conditions that expose the Company and its products to the risk of contamination.” Yes according to the complaint:

1. No board committee existed to address food safety;

2. The company had no regular process or protocol that required management to keep the board informed of food safety matters;

3. The company did not have a schedule for the board to consider food safety on a regular basis; and

4. While management received reports with compliance red flags, no evidence existed to suggest these were disclosed to the board. 

Summary of Key Holdings

The Marchand decision had two principal holdings.

Directors Must Exercise Informed Oversight of Safety and Compliance

The Court held that because “no system of board-level compliance monitoring and reporting existed at Blue Bell,” directors breached their duties under the court’s precedent, which required them to make a good faith effort to oversee company operations.

Key to the court’s determination were the facts that the Blue Bell board did not put in place “a reasonable system of monitoring and reporting about the corporation’s central compliance risks.” According to the Court, the board’s lack of effort resulted in it not receiving official notices of food safety deficiencies for several years until the outbreak in 2015.

Crucially, while the company management had systems in place to ensure compliance with regulations, the court emphasized this does not absolve a board of directors from its independent obligation to exercise oversight of those efforts.

Director Independence

The court also found that a director’s deep and longstanding relationship with Blue Bell’s founding managers was sufficient to call into question that director’s ability to impartially assess the shareholder’s claims. 

According to the Court, the lack of director independence turns on whether a director may feel “subject to [an] interested party’s domination or beholden to the interested party.”  

While monetary considerations are important to this analysis, the “law cannot ignore social nature of humans.” Because of the deep business and personal relationship between the director and management, the Court held that reasonable doubt existed as to whether the director could “impartially or objectively assess whether to bring a lawsuit.”

Evaluating Next Actions 

For companies in highly regulated industry like food and drug manufacturing, Marchand is a call to action to ensure board-level oversight of safety and compliance functions. What’s critical in this regard is that the board is regularly apprised of material information relating to safety and compliance and that the Board actively review that information and respond to it with appropriate oversight.    

While every company and board must determine for itself what constitutes appropriate oversight, examples of governance practices to this effect might include the following:

1.     Establish a board committee responsible for regulatory and compliance risks;

2.     Create processes and protocols requiring company management to inform the board of safety compliance developments, practices and risks;

3.     Maintain a quarterly schedule for the board to review and discuss regulatory and compliance risks; and

4.     Keep detailed minutes of board discussions regarding regulatory and compliance matters.

The Marchand opinion also underscores the value of independent directors to effective corporate governance.  As company operations mature, it’s important that its board include perspectives that are independent of incumbent management to better enable healthy and impartial oversight.

How To Turn Strong Performers Into Effective Leaders

Francesco Barbera and Scott Woodhill, Senior Director of Talent Optimization at Adroit Consulting, discuss a common challenge faced by founders: how to help strong technical performers become equally skilled as managers and leaders.

For obvious reasons, strong technical performers (for example, an ace salesperson or software developer) are often elevated into managerial and leadership roles though they may not have the skills or competencies needed in their new role.

The results can be hugely disruptive and costly.

In this conversation, Scott offers some key insights on how to approach this all-too-common challenge.

Some thorny questions we address: - Can leadership be learned? If so, how? And how do you know if training will be effective? - What can leaders do to help others become leaders?

We hope you find the discussion valuable. For follow-up questions, Scott can be reached at scott.woodhill@myadroit.com.

Why Do So Many Startups Incorporate In Delaware - And Should I?

Most emerging growth and publicly-traded companies in the United States are organized as Delaware corporations. While Delaware isn’t the best choice for all business incorporations, there are a number of very good reasons to incorporate a high growth startup in Delaware. Below are a few of the key benefits:

• Efficiency. In the United States, each of the 50 states has its own set of corporate laws. For businesses with national reach, it is impracticable for stakeholders and their legal or other advisors to learn the laws a new state. Delaware has become a kind of de factor “national” corporate law jurisdiction to solve this problem. Investors and other stakeholders and their advisors tend to be well-versed in Delaware corporate law, and widely-used legal forms and precedent are based on Delaware law. All of this facilitates negotiation, increases efficiency, and reduces cost.

• Flexibility. Delaware’s general orientation in corporate law is to respect the decisions of the principals forming the company. California, by contrast, takes a more paternalistic approach, imposing requirements by statute that Delaware leaves up to the parties themselves. For example, a Delaware corporation with 3 or more shareholders can have a single director on its board, whereas the same corporation formed in California must have at least 3 directors. California mandates class-based shareholder votes in certain circumstances, whereas Delaware generally allows the parties to determine when such votes are required. Delaware’s more deferential approach provides founders and other stakeholders with more protection and flexibility to negotiate terms that make sense for the business.

• Deference. All states require corporate directors and officers to manage companies consistent with the fiduciary duties of care and loyalty. But Delaware’s interpretation of these fiduciary standards is generally more deferential to management, reducing legal risks.

• Predictability. As businesses grow in complexity, clarity in the legal rules governing their operation become essential. Delaware has a well-developed body of corporate law providing corporate directors and officers unparalleled guidance in understanding and discharging their obligations and navigating complex governance matters, like takeover defensive measures, acquisitions, executive compensation, proxy issues, interested party transactions, shareholder voting matters, and so forth. Delaware law is also widely studied and written about by academics and practitioners, providing even more guidance and clarity.

• Administration. The Delaware Secretary of State, which handles the administration of corporate filings, is responsive, flexible and highly skilled. It’s possible to have a business filing returned from the Delaware Secretary of State within an hour, to give a trivial example that turns out to be really helpful amidst critical business transactions. (California’s Secretary of State, by contrast, is bureaucratic and unresponsive.) Further, Delaware has dedicated courts charged with the administration of its corporate laws, providing a reliable adjudicatory body with deep expertise in corporate matters to preside over business disputes.

• Taxation. In the U.S., business taxes are mostly based on a company’s physical location, not its state of incorporation, so contrary to a popular misconception, incorporation in Delaware will not, for example, help California-based business avoid California state income taxes. But Delaware does take a hands-off approach to state-level taxation that is helpful to businesses incorporating there.

Is Delaware Right For My Startup?

Naturally, the decision in the case of any particular business should be based on individual considerations in consultation with your legal and tax advisors.

That said, Delaware is a good choice if you are building a growth company that will seek funding from an institutional or geographically-broad base of investors, have a larger number of shareholders with varying interests, and/or involve operations and stakeholders in many jurisdictions.

If that is not the planned trajectory of the business, or if it’s not yet clear, incorporating in your home state may be the right choice, at least for the time being. If necessary, it is possible to convert your company into a Delaware entity at a later time, though doing so can becomes more arduous once a company has grown in complexity.

LLC or Corporation? Choosing the Right Entity for Your Startup

One of the first questions to address during the startup process is whether to incorporate as a limited liability company (LLC) or corporation. Both entities provide the benefit of liability protection and the ability to issue equity to investors and service providers.

But these entity type have different strengths and weaknesses depending on the specifics of your business.

Below are the key factors when choosing between these two corporate forms:

• Taxation. LLCs are taxed as pass-through entities, which means they are not taxed at the entity level. This enables the distribution of profits to owners on a tax-free basis. Of course, owners still have to report the profits on their personal tax return but the LLC itself does not pay tax on those profits. Likewise, this enables the pass-through of losses, which, especially in the early stages of a business, can be advantageous to founders who are bootstrapping or raising capital through debt and have other income to offset. Some of these advantages can be secured through a corporation electing to be taxed as an “s corporation.” But maintaining that election comes with restrictive requirements - such as limits on the classes of stock and shareholders - that aren’t suitable for growth-oriented companies. Corporations, on the other hand, enable the carry-forward of losses and the issuance of qualified small business stock, which have significant tax advantages. In short, analysis of the tax implications can involve a wide range of considerations particular to your business plans and objectives.

• Capital Raising. Many institutional investors are prohibited from investing in pass-through vehicles like LLCs or have strong preferences against them. For this reason, companies planning to seek institutional growth capital often incorporate as or convert into corporations.

• Equity Compensation. Both LLCs and corporations can issue equity to service providers but corporations can generally do so more efficiently. While LLCs can issue options, they cannot issue incentive stock options, which are tax favored options for employees. Because LLCs are generally taxed as partnerships, when they issue equity interests to team members, they must issue K-1s to recipients and maintaining capital accounts for them. The tax complexities can multiply quickly.

• Flexibility. While corporations are highly efficient, LLCs are highly flexible. The governance and ownership structure of an LLC is largely determined by the contract among its owners, giving the parties latitude to accommodate different business needs and scenarios.

• Legal Predictability. Corporations are the most well-established legal form for the conduct of business. Corporate governance matters and the legal principles that apply to them are well developed, providing important predictability and guidance in the conduct of a business.

For emerging growth companies with the clear intention to raise institutional capital and scale with large teams, formation of a c-corporation is almost always the most efficient and effective legal entity for the job.

For others, the choice of entity can be a more complex and nuanced decision. We always advise making the choice of entity decision in consultation with legal and tax advisors based on the specific plans for your business.

A Summary of Delaware Public Benefit LLCs

Benefit LLCs are a new entity choice in a handful of states, including Maryland, Oregon, Pennsylvania, and Utah. In 2018, Delaware joined this burgeoning group of states.

While the trend is young, Delaware’s adoption of this new entity is important. More companies call Delaware home than any other state, and it’s often an influential first mover with changes to its corporate framework, with other states following suit.

Similar to a public benefit corporation, Delaware defines a public benefit LLC as a for-profit limited liability company that’s “intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.”[1] And like the corporation version, these LLCs must have a Public Benefit that reflects a positive effect--or reduction of negative effects--of an “artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”[2]

This statutory framework allows the company to balance financial interests with the public benefit stated in its governing documents. And within the framework of a limited liability company, it offers entrepreneurs and founders the ability to utilize the flexible structure of an LLC and taxation benefits while aligning the company to public-focused mission.

This is valuable virtue signaling. It lets investors, advisors, employees, and customers know about the socially-conscious mission enmeshed into the framework of the business. It also creates ease for investors to assess the business because of new statutory requirements, including a mandatory statement every other year that reports on the company’s promotion of its stated public benefit. The statement must include:

• the objectives the company has established to promote the public benefit;

• the standards for measuring its progress;

• factual information based on those standards; and

• an assessment of the company’s success in meeting its objectives.[3]

If you’d like to learn more about Benefit LLCs to discover if this is a beneficial move for your business, we’d be happy to go through this new framework with more depth to determine if this will help you generate the impact you seek.

This article was written by our emerging companies associate, Chris Jones. You can reach Chris via email.

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[1] § 18-1202(a).

[2] § 18-1202(b).

[3] § 18-1205.