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Business Law
for the Start-Up Netpreneur

A Seminar On Fundamental Legal Issues

Stock Compensation For The Netpreneur

Ms. Moore: Good evening. My colleagues have told you how to structure a lean, efficient, moneymaking machine. I'm here to tell you how to keep the money you make. I'll start with the $64,000 question—or more, depending on what your company is worth. Why use stock compensation? Cash is a lot simpler—Why not simply stick with paying your employees in cash?

The first reason, and sometimes the only reason a business owner needs, is that stock is easy to come by. Cash you have to borrow, or worse yet, you have to earn. Stock you just have to issue. It's sort of like Monopolyâ money.

Second, and on a more serious note, stock gives your employees a stake in the success of your business. You want your key people committed to the success of the enterprise. You want their fortunes tied to the fortunes of the business. Giving them a share of the company is a good way to achieve that goal.

You are not going to care much about the accounting treatment of stock compensation until you go public, and then you are going to wish that you had cared about it earlier. Favorable tax treatment, however, is something that everybody cares about from day one. Stock compensation has some really wonderful tax attributes. One advantage is flexibility. A stock option is virtually the only type of compensation that allows an employee to choose when to recognize tax. Another advantage is that you generally pay tax at lower rates. In some circumstances, all of the compensation is taxed at capital gains rates, rather than at ordinary income rates.

Let’s look at the different types of stock compensation. What’s on the menu? The answer is: everything you ever dreamed of; the potential to become rich beyond the dreams of avarice.

There are many types of stock compensation: Nonqualified Stock Options, Incentive Stock Options, Discounted Stock Options, Stock Appreciation Rights, Restricted Stock, Phantom Stock, Stock Purchase Plans and ESOPs. I am not going to go through each of them and explain their tax attributes now, but I will illustrate how you might use some of the more common forms. In the accompanying slides you will find material that compares some of these forms, when they are taxed and at what rate.

How can you get the best tax results? This is usually the first question people ask me, and the answer is incentive stock options (ISOs). An ISO is a right to buy stock later, at the price that the stock was selling for on the date that the ISO was granted. As the stock appreciates, that right becomes increasingly valuable. You are not taxed when you are granted an ISO. While virtually any form of stock compensation can produce that result, the real advantage of an ISO is that you are also not taxed when you exercise the option. Most forms of stock compensation require you to pay ordinary income tax equal to the spread when you become the unconditional owner of the stock. The spread is the difference between what you pay for the stock and what it is worth when you get it. In the case of an ISO, however, when you exercise the option and become the owner of the stock there is no tax consequence. When you sell the stock, you are taxed at capital gain rates, which, you will see, are sometimes considerably lower than ordinary income tax rates.

All of these tax benefits do not come without a price. You will see that incentive stock options are subject to various restrictions. They can be issued only to employees. They have to be issued under a shareholder-approved plan. Here are the restrictions you might particularly want to focus on. There is a limit on the amount of stock that can be subject to an incentive stock option so this is not an unlimited tax benefit. If you are a 10% or greater shareholder of the company, your option must be granted at an above-market price. This is disconcerting, to say the least, to some folks. And last, but by no means least, ISOs are subject to alternative minimum tax. If you have to pay alternative minimum tax, you will lose some of the tax benefits that ISOs offer under the regular tax system. This takes a lot of ISO holders by surprise, so you need to be aware of it going in, and so do your employees if you are granting them ISOs.

Suppose you have maxed-out on ISOs, or for other reasons are not interested in them. Is there a less restrictive alternative? Yes. There is something called a Nonqualified Stock Option (NQSO), which is also a right to buy stock at a predetermined price. NQSOs are not subject to the various restrictions that apply to ISOs; but when you exercise an NQSO, the spread will be taxed at ordinary income tax rates and you will also pay FICA tax. The ordinary income tax rate is as much as 39.6% under the federal system, compared with zero, which is what you pay exercising an ISO.

It's fine to give an employee the right to buy stock at a bargain price, but if the employee doesn't have the cash to buy the stock, it's a right that is not of much value. This leads many people to ask how do you exercise an option without cash? There are lots of techniques, some of them more complicated than others, for helping the employee to exercise an option without a large up-front cash outlay. For nonpublic companies, the simplest one is stock appreciation rights. You just give the employee the right to receive the appreciation in the stock without having to buy the stock itself. You can settle a stock appreciation right either in cash or in shares of stock.

Because one of the main purposes of stock compensation is to retain and motivate key employees, you want to give some thought as to how best to structure a stock award to achieve this goal. A simple technique is to say that the employee can only exercise the option while he or she is employed by the company. The employee can't take the option, go work for somebody else, and exercise the option when it becomes valuable. A somewhat more effective technique is to provide that the option will not vest. That is, it will not become exercisable for a specified period of time after it is granted. Sometimes an employer will say that an option can't be exercised until certain performance targets are reached, for example, when the stock price rises to a certain level or the company is earning a certain level of profit. Restricted stock works the same way. You give an employee an award of stock, but you condition it so that if the employee terminates within five years after the date of grant, for example, the employee forfeits the stock.

What do you do if you expect the stock price to go up sharply? How do you protect yourself in the tax system we all have to live in? Well, if your options are vested, you exercise them immediately. When you exercise a non-qualified option, you will recognize ordinary income; but if the stock price is still low, you won't pay much tax. If you hold the stock for a year or more after you exercise the option, the appreciation you realize as the stock price goes up will all be taxed at the lower capital gains rate, not at the ordinary income rate. If you receive an award of restricted stock, you should consider making an 83(b) election. Generally, when you get a grant of stock that is subject to a restriction (for example, a requirement that you forfeit the stock if you leave the company before within five years), you are not taxed until the restriction lapses—five years out, in the example I'm using. However, you can elect to be taxed when the award is granted. Why would you do such a thing? Because, although you will pay income tax on the value of the stock, any subsequent appreciation will be taxed at capital gains rates. Because the capital gains rates are lower, it's often sensible to go ahead and pay the income tax early while the price is low if you expect a sharp rise in the stock price.

You have heard Bob and others say several times that there are some entities for which stock compensation is either difficult or impossible. For example, some entities have a limited number of shareholders and other entities don’t have stock at all. What do you do in those circumstances? The answer is, you can use something called phantom stock or a related concept, performance units. These are ways of measuring compensation by some benchmark that is related either to the value of the company or to the performance of the company. You might, for example, say to an employee, "Whatever the stock is worth five years from today, we will pay you cash equal to the amount of that appreciation." In that way, you can link an employee's performance to the performance of the company without actually issuing shares of stock. You also can use this type of technique to deal with valuation issues. It is often hard to determine what the stock of a closely held company is worth. You have to call in an appraiser to look at the books, and, by the time you've figured out what the company is worth, it's often worth something else. One way to avoid this problem is to use performance units and link them to something other than stock price, something like sales or revenues which are easier to measure and do not require independent appraisals.

We have talked so far about types of stock compensation that are generally used for key employees, although you can grant options all the way down the hierarchy. There are other types of stock compensation that are designed to be broad-based, to cover almost everybody in the company. I won't talk much about employee stock purchase plans (ESOP), because you probably won't want one until you are the size of IBM. Employee stock ownership plans are a different matter. They can provide a very favorable tax vehicle for doing a lot of things that small companies want to do. One of their best attributes is that they can provide very significant liquidity advantages and tax advantages for large shareholders.

Are there other things you ought to know about? Yes indeed. There are plenty of them. Some that you may particularly wish to focus on are those issues associated with going public. If you are handing out stock in your company, it's smart to look ahead. If you are planning to take the company public, you want to know what effect these stock grants are going to have both on your financial statements and on your ownership.

Trademark And Copyright Issues For New Companies

Ms. Gallagher-Duff: Now that we have resolved all of the complex corporate and tax issues, let's turn to some more mundane questions such as selecting your company name and the names of your products and services, as well as some copyright issues involved in Web sites.

Let's start with trademarks. A trademark is a distinctive word, phrase, symbol or design that is used to identify and distinguish one's goods: "IBM" for computers; "Kodak" for film. In the same manner, a service mark identifies and distinguishes services. Because the legal requirements for trademarks and service marks are the same, the term trademark is often used interchangeably to refer to both. Your company name also may be protectable as a trademark. Trademarks may be distinctive sounds, colors and shapes. They can be very important and very valuable business assets. Think of the value of the trademark "Microsoft" or "Yahoo" or "Netscape." The basic purpose of trademark law is to prevent confusion in the marketplace. Federal and state law provides that protection.

Let's talk about selection of a trademark or company name. Trademark protection depends on distinctiveness. Ask yourself, "Is the company name or trademark inherently distinctive?" If it is, it's entitled to trademark protection as soon as you start using it or as soon as you file with the Patent and Trademark Office an application for registration of your mark based on an intent to use the mark. That assumes, of course, that the application does mature to registration. The more distinctive the mark, the broader your scope of your protection. Conversely, the weaker your mark, the closer your competitors can come to your mark. Remember, the value of the trademark is in the goodwill that it symbolizes.

Think of it in terms of a spectrum of distinctiveness. At one end are generic terms, which are entitled to no trademark protection whatsoever. Generic terms are in the public domain. If you select a generic term for your company name or for your trademarks, anyone can use the term. An example might be "All News Channel," for television broadcasting services.

Next on the spectrum of distinctiveness are descriptive terms. The public has come to associate your trademark with your particular product or service. Such marks are often desirable from an advertising point of view because they immediately convey to the consumer something about your product, its intended use, purpose or function, however, it's not protectable unless it has acquired distinctiveness.

Next on the spectrum are three other types of trademarks: suggestive marks, arbitrary marks and fanciful marks. They are all inherently distinctive, and they are all entitled to trademark protection as soon as you start using them or file an intent-to-use application with the Patent and Trademark Office. An example of an arbitrary mark is one where a common word is used to apply to goods in an arbitrary way. "Apple" computers and "Camel" cigarettes are good examples. Fanciful marks—a term invented solely to serve the purpose of functioning as a trademark—are entitled to broad protection. "Kodak" is a great example. Again, the greater the degree of distinctiveness, the greater degree of protection for your mark.

Let's talk about trademark clearance. Now that we know what kinds of trademarks are preferable, the next step is to determine whether your proposed mark or company name is available for use. Before adopting one, make sure that it's not infringing someone else's mark. You also want to make sure that it is not diluting a famous mark because there are special protections for famous marks. You don't want to find yourself in a situation where, after spending considerable time, effort and money, you launch a new product, only to receive a cease-and-desist letter from someone demanding that you stop using the trademark. It's better to do your homework first.

There are some clearance steps that you can do yourself at the initial decision stages, including a search on the Internet to see the extent to which the proposed mark is being used, if at all. Also, do a search of domain name registrations, because domain names, if they function as trademarks, are protectable under trademark laws. Another useful tool is a preliminary screening search. This is very inexpensive. It can be done on an in-house database of US Patent and Trademark Office records. It's very useful in paring down the list of proposed marks. It will tell you if there is an identical or nearly identical mark registered with the Trademark Office. If your mark is registered by someone else for the same or related goods or services, it's a no-go. Assuming that all of these steps have been fruitful, the next step should be a full trademark search. We highly recommend this. It's better to spend a few hundred dollars for a full trademark search because (although they are not foolproof) they substantially reduce the risk that someone will come out of the woodwork after you have picked your company name or trademark and prepared your stationery and launched your product. Full trademark searches are done by trademark research firms. They cover the records of the Patent and Trademark Office, state registration records, various trade directories and company name databases.

If you are selecting your company name, then you want a company name search. It will cover the registrations of company names in virtually all the states and, to some extent, limited partnership names as well.

In deciding whether or not a mark is entitled to use and registration, you have to consider whether the mark is being used on related goods or in connection with related services in your particular area.

After you select a mark, there are several steps you can take to protect it. Let's start with federal registration, which gives you significant advantages and can be quite inexpensive (if no one opposes your registration) including the fact that it is deemed prima facie ownership of the mark, so you are entitled to exclusive use. If you have not obtained federal registration, it's important to use the "TM" and "SM" symbol. They have no legal significance, but they have a lot of practical significance because they put the public and potential infringers on notice that you view those marks as trademarks. It's very useful. Once you are registered there are legal benefits to using the federal trademark registration symbol (®) although you are not obligated to do so.

Other steps you can use to protect your mark include monitoring the use of marks by other people which are the same or confusingly similar to yours. There are various watch services that do this. You should be diligent in monitoring other people's marks in order to stop infringement. In addition, if you use your domain address as a trademark or service mark, for example, if it is prominently displayed in marketing or promotional materials, you can obtain federal registration of that as well.

Let's turn briefly to copyright issues. Like trademarks, copyright falls under the umbrella of intellectual property, although it has a different purpose and a different function. Copyright extends to original works of authorship. It does not protect ideas. It protects the original expression of ideas in a tangible medium of expression. It protects literary works such as novels and books. It can protect computer programs, compilations of databases, pictorial and graphic works, audio visual works and musical works. The copyright holder’s rights are very important. The holder is the exclusive owner and the only one able to make copies of the work, distribute the work, to display the work publicly and to create derivatives of the work.

I'm going to talk briefly about copyright issues involving Web sites. It is important to determine ownership of your Web page design. Generally, if it is designed by an employee within the scope of his or her employment, then copyright ownership presumptively vests in the employer. However, if the author of the work (the Web page design, for instance) is an independent contractor, then there is a presumption that copyright ownership vests in the independent contractor, not in the company hiring the independent contractor, unless there is a written agreement to the contrary.

It's very important, at the outset, to determine what intellectual property rights are involved and who owns them. Before posting any graphic, written, audio or visual material on your Web site, determine whether you are the author. If you are not the author, is the work in the public domain? If the work is not in the public domain, then you need to seek permission from the copyright owner to distribute the work electronically on the Internet. It is important that your permission extends specifically to the electronic transmission of the work. Also secure from the copyright owner the right to adapt or to make derivative works on the copyrighted work. Another important thing is to obtain from the copyright owner, or from the copyright author, warranties and other protections from infringement. Lastly, it is useful to have a copyright notice on your Web site. Your company should post an appropriate warning message regarding the appropriate use of copyright works that appear on the Web site and use by online users. You may also want to post copyright management information that sets forth terms and conditions for the use of the material that appears on the Web site.

Employment Agreements

Mr. Huvelle: All companies with employees face a range of obligations. It is important to look at an overview and to determine, first of all, what you are trying to accomplish. Essentially, you want to attract, retain and motivate highly skilled employees. What you want to avoid is litigation, and, if you do run into litigation, it is helpful to win.

Unlike some of the other areas we have been hearing about, employment is, fortunately, one where common sense helps and will get you a long way towards your objectives. There are many, many statutes regulating employment and telling you precisely what you can and cannot do in terms of how you must treat employees. It is important to remember that basic fairness counts a lot. If you treat employees fairly, you will avoid many problems. When you terminate an employee, for example, fairness really means letting him know what you expect, telling him if he is failing to meet that standard, giving him an opportunity to improve—to correct the problem—and treating him consistently with others. For litigation purposes, what is important is not that you have any particular form of documentation, but that you are able to demonstrate to others that you have treated people fairly; that you have counseled them and let them know what is expected.

The issue of written agreements comes up in a couple of ways. Even in a very small company, you will often enter into an employment relationship with an individual by sending a letter confirming the terms of employment. It is important to remember that no matter how you document your relationship with an employee, the employment relationship is a contract. It may be a written contract or an unwritten contract, but it is a contract.

If you simply say to a person that you are going to employ them and pay them a certain rate per hour or per week, then that is an employment-at-will agreement. Employment-at-will is a great benefit for employers because it means that you can terminate the employee at any time, for any reason or for no reason, and the employee can leave at any time and for any reason. It is helpful to be an employer at will, not because you want to terminate employees for stupid reasons or no reason, but because if you do terminate an employee, you do not have to justify that action. The employee may disagree with you, may think it was unfair and unwise, but, if the employment relationship is at-will, that is not a sufficient basis for litigating over the termination.

If you send out a basic letter saying, "We are happy to employ you starting on this date at this salary and your job title is going to be such-and-such," that is a written contract, if the employee accepts. The tendency, and the big mistake that many employers make—large and small—is to enter into one of these agreements on the assumption, belief and hope that everything will work out perfectly and that the individual you tried so hard to locate, attract and persuade to come to your company will turn out to be an excellent choice.

The difficulty, of course, is that sometimes you are wrong, and it doesn't work out. Typically when you and the lawyer then go back to look at the agreement, it says nothing about the possibility of the relationship not working out. It doesn't set forth the grounds on which the agreement can be terminated, and it doesn't specify the consequence of such termination—whether or not there is severance pay, etc. Sometimes this is because you don't think about it; sometimes it is because you cannot recruit the person if you say that you can terminate him at any time or for any reason; and sometimes you think it is awkward in the recruiting context to say to the person, "This is a great company, we think you are going to have a great future with us. You are just the person we want and if we decide to terminate you, this is what's going to happen." It is helpful, however, to anticipate the possibility that the relationship will go sour. One way of doing this is to provide that if you terminate the person within a certain time period and for certain reasons, then there will be severance, or you will give him a certain amount of notice. Unless you state the relationship is at-will, it makes sense to deal in the agreement with the possibility of termination, the grounds for termination and the consequences, namely, severance pay.

Another kind of agreement that you may want to enter into with employees relates to confidential information. Most of you are in a businesses, or hope to be in a businesses, where the very essence of the business is knowledge and information. That's the key to your success. There are a couple of ways that you may try to protect this information and to ensure that once you bring the employee up to speed and get her familiar with all your special methods, that she does not then leave and set up her own company to compete against you. The first approach is to deal with confidential information and trade secrets through a non-disclosure or a non-compete agreement. Even in the absence of a written agreement, an employee has a common law fiduciary duty not to disclose confidential information that he or she has acquired from an employer. That is the duty of loyalty. You can supplement that common law duty with a written agreement, spelling out the employee's obligation not to disclose the information. There is practical difficulty, however, with nondisclosure agreements and with the fiduciary duty. The problem is one of enforcement.

Suppose an employee who has access to your confidential information—your customer list, your way of doing business, your key ingredients—leaves and joins another company. You believe that the employee will disclose the information to the new employer. The difficulty is proving it. If you ask the employee—once you institute litigation and take the depositions of the person and his new employer—what response will you get? The response will be that he is shocked at the suggestion that he might violate your confidence. You need to prove it. Secondly, courts tend not to be sympathetic unless there has been a violation. If you simply say that you fear someone will violate the obligation, the courts are not going to view that as one of their top cases. From your point of view, the court is, in effect, applying a "one free bite rule." Once the confidential information is disclosed, however, you have lost. You can't put the genie back in the bottle. If you do win, you get an injunction prohibiting the employee from disclosing the information to his employer and where are you? You don't know what he is going to do the next day; whether he will disclose your confidential information or not.

That leads to another approach, which is a non-compete agreement. This is an approach in which you simply say that the employee will not go to one of your competitors in a certain geographic area during a specified period of time. Of course, there are difficulties with this approach, too. The courts view this as a restraint of trade and a restraint on the employee's freedom to better herself, to find a better job. Some courts reason that if you really want this employee so much, pay him or her more and then he or she will not leave. So, the courts have established a number of requirements that you must satisfy in order to show that your restraint on the employee's freedom to improve herself is reasonable. The three criteria are:

  1. The restraint must be no greater than necessary to protect your interests.
  2. The restraint must not be unduly harsh on the employee.
  3. The restraint must not be contrary to the public interest.

There are three types of restrictions that you can impose on the employee, three parameters at which you have to look. One is that when you are restraining the employee's freedom to go to another competitive job, you must limit the type of activities that he or she is prohibited from engaging in. You can't simply say, "For two years, if this person leaves our company, he will remain unemployed." That is not acceptable. You have to limit it to particular activities that are similar to what he was doing for your company. Secondly, the time period must be reasonable. You can restrict the former employee generally for two or three years, but not forever. Third, the geography of the restraint must be reasonable. This perhaps is the most interesting requirement for people in businesses such as yours, because the law has developed over many, many decades. The idea of a reasonable geographic scope was based on the notion that you could restrain a salesperson from marketing similar products, maybe in the same county, perhaps 60 miles from where your store was located. Those concepts don't apply very well when we are talking about the Internet or electronic commerce, because businesses are no longer located in one area, and, for restraint to be effective, it cannot be limited to a particular county. For instance, in Virginia, which is one of the best states in the country to be located in if you are an employer hoping to enforce a restrictive covenant, many of the cases still speak of a geographic scope. Our firm actually had one of the leading cases in Virginia where we were able to persuade the court to look at the restraint issue from a broad point of view in terms of modern commerce. Still, the court clung to the notion that non-compete agreements are meant to provide restrictions over a limited period of time and in what the court said was, "your own neighborhood." But this does not really deal with the fact that, in this day and age, your neighborhood may be an electronic one that extends throughout the world.

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