The Social Network: Business Ideas – Legal Protection = Philanthropy

My wife and I saw The Social Network this past Saturday which tells the story of how the social website phenomenon Facebook started. Although I try to leave my law practice out of my weekend entertainment, the movie vividly highlighted how the story might have been very different had any of the protagonists had some friends over at Langdell Hall where Harvard law students study.

The Winkelvoss brothers offer computer programmer extraordinaire Mark Zuckerberg a sandwich as they casually explain their idea for a social networking site they wish to call Club U. The site will allow Harvard students to follow other Harvard friends via a website. They ask Mark if he can write the code for the site. Mark readily agrees, they shake hands and shortly afterwards Mark decides he can take the idea and do it better. This scene might have played out differently had the brothers trekked over to Langdell Hall. Had they done so, they might have insisted Mark sign a non disclosure agreement for the idea prior to disclosing the idea to him. They, moreover, would have asked him to sign an independent contractor agreement where all the code he developed belonged to the Winkelvoss brothers. At the time they pitched the idea, the Winkelvoss brothers has no idea Mark might take their idea and start his own business. Does that sound familiar? In the movie, the Winkelvoss brothers came from a privileged background and had the financial ability and legal contacts to sue Mark Zuckerberg. Most of the time, however, entrepreneurs dealing with Fortune 500 companies have neither the means nor the time to fight these companies if their ideas are stolen.

Mark Zuckerberg starts his online site “The Facebook” and enlists the help of his friend Eduardo Saverin to start and grow the business. They have a conversation where Mark tells Eduardo that Mark will own 70% of the company and Eduardo will own 30%. A handshake deal among friends nothing in writing. Later in the movie, Mark meets Sean Parker who tells Mark to move to Silicon Valley as that is where the action is to grow the business. Eduardo does not like Sean and thinks Sean should not be part of the company. Mark successfully obtains a $500,000 angel investment and Eduardo is asked to sign some paperwork reincorporating the company in Delaware while giving him 35% of the company. Eduardo, without an attorney, signs the paperwork. Later Eduardo realizes he did not understand the fine print which allows the company to reduce his shares while the other founders shares are not reduced. Eduardo laments that he did not have a lawyer representing him. He simply believed what the lawyers representing the venture capital company told him about owning 35% which was true. They simply chose not to tell him that he could be diluted later when additional investors put money into the company. This story echoes a familiar refrain: a business deal turns deadly as a result of the details when you fail to consider the “what if”. Here the “what if” was what if additional funds are put into the company, are the founding shareholders ownership reduced? The question wasn’t asked because Eduardo lacked intelligence, it went unasked because he did not have experience with venture capital firms and how their deals work.

Given all the mistakes that occurred and the money involved once the idea really took off, litigation inevitably ensued with the Winkelvoss brothers and Eduardo separately suing Mark Zuckerberg. At his deposition, Mark’s arrogance and sarcasm become abundantly clear. Litigation is a lot like going to Las Vegas, the likability factor of the people involved and chance often trump the facts and the law. In the movie, a competent lawyer would have easily been able to paint Mark as an arrogant person who betrayed his friend’s trust as well as stealing an idea from other Harvard students. This factor, among others, persuaded Mark to write a sixty-five million dollar check to the Winkelvoss brothers and a separate undisclosed sum to Eduardo and acknowledge him as a Facebook co-founder.

The Social Network highlights how well intentioned entrepreneurs who simply trust their business partners watch helplessly as others capitalize on their ideas. Friendship is also put to the test when friends embark on a business venture with no written agreements then start to have disagreements on the direction of the company. Absent a simple non disclosure agreement and a independent contractor agreement, the Winkelvoss brothers watched in horror as Mark Zuckerberg turned their idea into an international phenomenon. Eduardo Saverin, absent competent legal counsel, signed legal agreements that sealed his ultimate departure from the company. Unlike most entrepreneurs who have their ideas stolen, the Winkelvoss brothers and Eduardo Saverin managed to obtain compensation for their efforts in Facebook’s creation. Most entrepreneurs who make these same mistakes are far less fortunate and find the lesson learned painfully expensive. They should never forget a very simple equation: Business Ideas – Legal Protection = Philanthropy.

Justin S. Daniels, JD, MBA
Trusted Practitioner of Practical Legal Advice.

Get Emotional Over Litigation at Your Peril

Clients often get upset with the behavior of a business partner and wish to sue them back to the stone age. The story often includes something like they promised high quality or responsiveness and they did not deliver. Calling your litigation attorney ready to fight should probably not be your first phone call. Instead you should consider how does this litigation further my business strategy? How much time and attention away from my business will this litigation entail? Is it worth the allocation of my resources?
While litigators litigate, on the other hand, smart corporate counsel ask these questions and help figure out if litigation makes business sense. Senior management usually regrets the decision to litigate when they get caught up in their hard feelings over not being treated fairly. At some point in all our lives, business partners will not live up to expectations and those who approach these issues based on the facts and not emotion make the best decision. In all my years practicing law, the agony of the interminable litigation process overshadows the feeling that justice was served even in ultimately successful lawsuits.

Hiring The Right Professional Pays Off Over Time

I have certain clients who pass through my office who are thinking about hiring a lawyer for the first time or switching lawyers for the all too familiar reasons. They, however, make it clear all they really care about is getting the cheapest price for the services. How often do you hire the cheapest provider only to lament later that “you got what you paid for”.

This is a short term outlook that has become so pervasive in our society that we forget it usually costs us more time, money and effort in the long term. Instead, take the time and make the effort to identify and choose the right lawyer. If your lawyer won’t invest the time to get to know you, your business and your industry, why would you expect them to provide you first rate counsel when you really need it. Many clients I have worked with over many years actually save money on legal fees because I know them, their main agreements, customers and businesses. The investment you make now hiring the right lawyer pays off with better and more efficient counsel when you need it in the long term.

Hidden Requirements in the New Health Care Legislation

Some like it, some hate it, but March 23^rd, 2010 marked a historic event for the United States: the signing into law of the Patient Protection and Affordable Healthcare Act, a bill that will undoubtedly change the way that healthcare is administered in this country. However, as is the case with most legislation, the Act contained a number of provisions not directly related to its primary purpose. With most Americans still at a loss as to what changes were actually enacted concerning healthcare, it is only understandable that most are also completely unaware of these less salient add-on’s, even of those with the potential to effect daily life. One such provision, an amendment to the Federal Food, Drug, and Cosmetic Act, promises to significantly impact restaurant franchises and vending machine operators.

            In an effort to aid consumers in their dietary choices, the amendment places new requirements on the types of nutritional information that businesses must provide and the ways in which they must present it. The amendment specifically targets food establishments that are part of a chain of twenty or more locations and people who operate twenty or more vending machines. Under the amendment, these groups must now clearly and conspicuously display the number of calories contained in all standard and some non-standard food items sold. Notably, the information must be presented in the context of the suggested caloric intake of a daily diet. The details of the amendment’s requirements are outlined below:

Items Affected by the Amendment

• Standard menu items
• Specials or temporary menu items that appear on the menu for at least 60 days out of a calendar year
• Items that are part of market testing that appear on the menu for at least 90 days out of a calendar year
• Food items sold from a vending machine that does not provide visible nutrition information at the point of purchase (such as on the food wrapper, facing outward)

 

Nutritional Information Required by the Amendment

• The number of calories contained in an item, to be displayed on menus and menu boards on which the item appears, on signs placed adjacent to any self-service food or beverages, and on signs in close proximity to any vending machine items
• Suggested daily caloric intake, to be clearly provided in succinct statement on all menus and menu boards
• Written nutritional information, to be available on premises and upon request, as well as a statement regarding the availability of such written information prominently displayed on all menus and menu boards

           

            The amendment requires that the Secretary of Human Services issue regulations before its provisions can take effect; however, the Secretary is required to finish this task by March of 2011. Regardless of the regulations eventually promulgated, the amendment promises to impose significant legal obligations on franchise restaurants and vending machine operators. The parameters of these obligations will almost certainly be a topic of litigation in the years to come.

Don’t Wait to Last Minute to Negotiate Critical Lease Provisions

There are three critical lease provisions that tenants should negotiate at the outset rather than negotiating them as part of a lease review. These provisions are the following:

1) Identifying the buildout completion date and the penalties for landlord’s failure to timely deliver. These are typically 2 days free rent for each day’s delay and if such failure lasts beyond 30 days the right to terminate the lease.

2) The right to assign the lease to a creditworthy tenant and a release from any further liability after the assignment.

3) A cap on common area maintenance (CAM) charges or a cap on the subset of these charges called controllable expenses (i.e. the expenses that can be bid out like landscaping, management company, etc.)

In my experience, these provisions can critically impact a tenant’s bottom line yet many times they are not negotiated at the outset along with the base rent, term, and other financial terms. The problem that arises is the landlord will not easily budge on these issues and the tenant is invested in the lease process and is reluctant to walk away from the lease after having spent so much time negotiating the business terms. The CAM cap issue, in particular, can significantly impact tenants in this economy where landlord’s are hurting and looking for all kinds of ways to pass along CAM charges to tenants. Don’t assume a landlord’s history of fairness will mitigate the concern here as I have seen property portfolios sold to new landlord’s in the last few years who overpaid and now need to recoup that investment by foisting CAM costs on unsuspecting tenants. In short, these three issues appear in almost every lease and tenants should negotiate them at the outset and not wait until they receive the lease.

As always your trusted source for practical legal advice

Justin Daniels

Do Your Due Diligence or Be Sorry

I have many clients who call me at the 11th hour to request a contract and tell me not to worry about any due diligence that may get in the way of their sweet deal. That is a sour response.

Due diligence may seem trite and monotonous but it is essential to making sure you receive what you expect. Do the financial statements justify that purchase price? I recently reviewed a survey on a real estate transaction with a seller who owns real estate all across the southeast. The survey clearly showed that the seller built storm water and sewer lines that traversed the adjacent property and there was no easement for those lines. If my client purchases the property without the easement he takes the risk that the adjacent landowner may demand that my client remove the pipes or pay an exhorbitant price for an easement. How would you feel spending 5,000,000 to close this transaction and then find out about this problem. A mere hour spent reviewing a survey identified this problem.

Whether you are hiring a CEO, inking a new strategic partnership or purchasing a business, there is no substitute for good old fashion due diligence. In my experience those who really pay attention to the small details become successful businesses. Those who don’t usually call my office after the fact upset at others when they simply need to look in the mirror for the culprit of their misfortune.
As always your trusted resource for practical legal advice.

Your Contract is Your Bond

I have fielded several phones calls lately with the same lament: “The contract I signed is not what the supplier promised.” I am sure you have heard the phrase “My word is my bond”, today that really means “Your contract is your bond”.

Most contact boilerplate contains a clause that says the contract supersedes any prior discussions that took place prior to executing the contract. This means that you need to make sure the contract accurately reflects the party’s intent. If a problem arises later, in most instances, the contract language controls and prior discussions are meaningless.

Don’t assume the contract merely memorializes your agreement, more often than not, you will find there are important details that need clarifying. For example, you may have understood the purchase price was paid in installments. If the executed contract says the purchase price is paid in cash at closing that language will control and the prior discussion is meaningless. That is why its so critical that you make sure all the letter of intent items are properly memorialized in the contract.

Justin Daniels

Is an LLC Unit a Security?

Most securities laws apply to what the laws themselves define as “securities”. Unfortunately, most definitions are not exhaustive and we are forced to look to the court’s for guidance.  For years, the Supreme Court’s decision in Securities & Exchange Commission v. W.J. Howey Co. has provided the three prong test in determining if an investment contract is a security.  The three prongs, did the person (1) make an investment, (2) in a common enterprise, (3) with the expectation of profit solely from the efforts of others, still control.

When trying to apply the test to LLC Units the clearest test put forth by the courts is found in Williamson v. Tucker, which involved a venture that owned undeveloped real estate.  In Williamson, the court first noted that each partner had an interest (making it an investment), the venture pooled the investors resources (making it a common enterprise) leaving the last issue – did the investors expect to profit solely from the profit of others?  The most important issue in the third prong is generally the management of the LLC.  While LLC’s by default are member managed, many are manager managed and the LLC Unit holders may “expect to profit solely from the profit of others.”  This creates a facts and circumstances test and various factors that should be considered.

Be sure you consider the issues created by state and federal securities law before you make any decisions with you new or existing LLC.

Are You Feeling Lucky? What are the chances of being audited

In FY 2009 138,788,744 total individual income tax returns, that were required to be filed, were filed and 1,425,888 were audited; roughly 1%.  Only 22.8% these audits were conducted by revenue agents, tax compliance officers, and tax examiners; the bulk of the audits (about 77.1%) were correspondence audits.

For individual returns showing income of $200,000 to $1 million, 2.3% of returns not showing business activity were audited, and 3.1% of returns showing business activity were audited, versus 2.6% and 2.8% respectively in FY 2008.

For FY 2009, the audit rate for returns with total positive income of $1 million or more was 6.4%, versus 5.6% in FY 2008.

For all corporate returns, other than Form 1120S, the audit rate was 1.3%, the same as FY 2008.

Selling An LLC Unit Is Not The Same As Selling Stock

There are various differences between an LLC unit and a share of stock.  One of the most important should be focused upon by you and your advisor when selling or abandoning an LLC unit.

Phantom Income.

An LLC member may be required to recognize income at the time of a sale that may otherwise create an economic loss.  This can occur in one or both of two ways.  First, if the losses deducted have exceeded the investment in the LLC, the selling member may recognize gain on the sale, effectively recapturing losses previously deducted.  Second, if, at the time of the disposition, an LLC has either unrealized receivables, appreciated inventory, or both, the selling member will have to recognize ordinary income.

Nature of the Income.

The nature of the income from selling an LLC unit may also be different.  The sale of an LLC unit usually triggers some ordinary income because the rules that apply to unrealized receivables, depreciation recapture, substantially appreciated inventory, and other assets.  In contrast, the sale of stock triggers ordinary income treatment in the less frequent collapsible corporation situation.  Alternatively, the abandonment of an LLC unit results in an ordinary loss while an stock, when worthless, is deemed a sale of the stock and the resulting loss is a capital loss.

The time to consider these difference is not when selling, but when forming your entities.  Nevertheless, talk with your advisor understands the tax implications from the sale of LLC unit and can work with you to achieve the best results.

A.J. Rollins