Whether you're a start-up entrepreneur or an experienced small business owner, you will get a lot out of this edition of Deal Talk, because no one wants to subject themselves to corporate litigation that can devastate both you and your business. Is your business a formally recognized legal entity? Is it the best structure for your type of business? Beyond that, have you protected yourself and your business partner—if you have one—with a founder's agreement? Do you conduct any transactions over the Internet? Participate in interstate or overseas commerce? If so, you need to consider the legal issues. We're pleased to welcome Annal Vyas, attorney and visiting Professor of Clinical Law at the University of Akron to help us understand the top legal challenges and—importantly—how to avoid them.
Once you start a company, let's say there's two people involved, it's really like a marriage. You need some type of founders’ agreement, some sort of operating agreement if you're an LLC, or some type of shareholders’ agreement and by-laws if you're a corporation that really outlines the rights and responsibilities of each party. And I did think conceptualizing that is a pre-nup for your business is a helpful analogy.
- Annal Vyas
There is so much to know and remember when it comes to protecting you and your business from exposure to litigation. It really makes your head spin when you think about it. But we're talking about the kind of litigation quite frankly that if you come out on the losing end could mean financial devastation and nobody wants that. On this segment on Deal Talk we're going to discuss some of the most important items or issues you need to address in order to reduce the risk of legal challenges and substantial financial loss. Joining me on the Morgan & Westfield guest line is Annal Vyas, he is an Attorney and Visiting Professor of Clinical Law at the University of Akron School of Law in Akron, Ohio. Annal Vyas, welcome to Deal Talk. Good to have you, sir.
Annal: Thanks for having me. It's great to be on.
Jeff: We've got really essentially a top ten list. These are not necessarily ranked I don't think in any particular order Annal, but if we could go ahead and get started with the first item here on our list. We're talking about entity selection and why this is an important thing to think about and consider.
Annal: It's absolutely critical for any business they consider and actually before I start talking about entity selection I should say that no listener should construe this as legal advice particular to his or her situation and there's no attorney/client relationship being formed. I'm licensed for tax law in Ohio, not other jurisdictions. So I just want to get that legal disclaimer out...
Jeff: Thank you Annal. That's important. Thank you.
Annal: It's just a general discussion about entity selection and it's really important because if people ... Let's say you start an ice cream store and it's just you. And you sell an ice cream, things are going well, but you make a mistake and then all of a sudden you sell ice cream that's expired and then some kids get sick. All of a sudden they're in the hospital and there's hundreds of thousands of dollars of hospital bills. What a lot of people don't realize is that their personal assets are absolutely at risk. There's no division in the eyes of the law between their business and their personal assets. They're one and the same. And so the parents of the child can go ahead and sue you for hundreds of thousands of dollars and you might think, "Oh my god, I didn’t realize that." The second scenario is that I see a lot is that people go into business with a friend of theirs. So let's say that you have the same situation where you do an ice cream store with your best friend and let's say it's not even you who screwed up, it's your best friend who screws up and sells the expired ice cream. Under the law the parents can go after you even though you didn't do anything wrong and not only can they go after you they can go after you for the full amount. And so it's called a general partnership under the law and the doctrine of joint and several liability. So even if I didn't do anything wrong I could be exposing myself to hundreds of thousands of dollars in law suit damages. And so it's really, really critical that a company organize some entity under whatever state. And when you organize an entity basically you're filling out some forms with the Secretary of State. And in exchange for filling out that form and paying the money -- it's generally around $100 depending on the jurisdiction -- you've basically given birth to a separate person. I think that's a good way to conceptualize your business. Now that you have the separate person, it's a separate person who's operating the business and let's say that someone screws up and has the ice cream example in that scenario, well then the assets are limited to whatever the assets of that entity are. And so it's absolutely critical that that formation takes place.
People always try to figure well, really what state should I organize in and also should I be a limited liability company or a corporation. And really again, this is a conversation you have to have with the lawyer that's really specific to your situation because there's so many idiosyncratic things that can impact the choice of entity and the state where you are going to organize. But again, at the very high level, I would just say from my experience 90 percent of what I organize are domestic LLCs, so Ohio LLCs But then 10 percent of the time I kind of do organize Delaware Corporations. And there's some lawyers who say you have to do a Delaware Corporation every single time or else you don't always ... I think again, it really depends on the facts of the scenario but at a very high level. You can think of the differences between an LLC and a corporation. I guess I'll tackle that question first.
An LLC, you can think of it as it gives you the same benefit to the corporation from a liability perspective. A lot of people think the corporation's more formal and therefore it gives me more liability protection. That's not true. You get the same amount of liability protection in that ice cream example if you had organized either as a corporation or as an LLC. But it's the LLC by default is beneficial from a tax perspective. So the LLCs only have one level of taxation whereas the corporation has two. It's called double taxation. And the best way to describe that is if you think of owning stock in Ford Motor Company. Ford itself as a corporation will pay corporate income tax. So that's one level of taxation. But then the shareholders at Ford when they sell their shares they'll be subject to long-term capital gains tax or short-term capital gains tax, or taxes on dividends, all that stuff. So there's really two levels of taxation. One at the corporation level and then another at the shareholder level. The LLC avoids that issue of double taxation by a default perspective. So a lot of people feel that it's beneficial in that regard and also it's a lot easier at least in Ohio to maintain the formalities of an LLC versus a corporation. I'm kind of just talking here but I think that's worth getting into a little bit is I gave that example of someone ... Let's take my previous example and let's say someone forms an LLC for their ice cream store. You can't just form the LLC and then not represent out to the public that you are an LLC, because if the public doesn't know that you're an LLC you can still get sued. I didn’t explain that very well. But the bottom line is it's easier to maintain the formalities. You don't have to have minutes necessarily. You don't have to annual meetings and all that jazz. So that's another reason why LLCs are sometimes preferred for smaller if you're just starting out. So the million dollar question is generally when do you prefer a corporation versus an LLC? And the answer is really if you know you're going to be seeking a lot of venture capital.
Big institutional investors love to see a Delaware Corporation. That's what they're most comfortable with. Delaware is a nation leader in corporate law, and so it’s just got this saying, people really say Delaware's the leader, it's true. I always joked that each state is known for something, like California's known for movie making, Nevada's known for gambling. I'm from Ohio so I'm going to say that Michigan is known for sucking. But Delaware is known actually of being the nation's leader in corporate law.
it's really, really critical that a company organize some entity under whatever state
Jeff: There you go. We could probably talk about that, that one item. We got a list of top ten that we could probably go on and discuss over the course of two or three shows but we need to move forward here. Let's talk about the founders’ agreement, it's very, very important here. A lot of things can go wrong. Tell us a little bit about why this is important.
Annal: Once you start a company, let's say there's two people involved, it's really like a marriage. You need some type of founders’ agreement, some sort of operating agreement if you're an LLC, or some type of shareholders’ agreement and by-laws if you're a corporation that really outlines the rights and responsibilities of each party. And I did think conceptualizing that is a pre-nup for your business is a helpful analogy. I can give you some quick examples very briefly of why that's important. Let's say for example two people are in the business and then one person wants to leave and sell to a third party. The person who's remaining in the business says, “I don't want you to sell to that third party, I can't stand that third party.” How do you take care of that situation? Normally that's taken care of through a vehicle such as a right of first refusal which I won't get into now. But there's ways to deal with that scenario. If you're a startup company and you're leaving your company, how do you value your shares?
Another really, really common but critically, critically important concept is the concept of founder vesting. And so a brief example of that is let's say I'm starting my own LLC but I want to bring someone on in order to code the website that they need to take care of. But I don't want to give them 50 percent of my company upfront, I want them to give certain deliverables, or I want them to be working at my company for a certain period of time before their booty actually realizes. Because I want to protect myself because let's say the guy or girl doesn't deliver. All of a sudden I forfeit half of my company without any product, and that could be a problem. And then finally I'll just say this is another common scenario. I actually had a marriage dissolve in front of me, i.e. a company. There were these two founders who were just bickering in front of me and I felt like I was in middle school. Because one person has put in all of the money, like $20,000, and the other person didn't put any money in. And so the question was: when they start making money does the $20,000 gets repaid to that person who put in first before you start doing the 50-50 split, or 51-49 split. Or is it just hey, it’s some cost as part of getting your equity. There's a lot to consider.
Jeff: I'll say there is and I can see where that could probably head into the courtroom if that's not headed off at the pass and something isn't done in advance on the founders’ agreement. The third item we need to talk about, intellectual property and the importance of securing that intellectual property, very critical.
Annal: Yeah, absolutely. When I say intellectual property people often ask me foundationally what does that mean. And you can think of intellectual property as property arriving from your brain. And it really shares a lot of the same characteristics as real property in the sense that ... Let's say that I have an apartment complex or I own a building I could lease or I could sublease parts of the property to tenants. I can lease if you will or license part of my patent portfolio, or the copyrights that I own. And generally speaking there's really four types of intellectual property. There's trademarks, there's patents, there's trade secrets, and there's copyrights. Sometimes something called the right of publicity is grouped into a conversation of intellectual property, but I won't get into that. You want to make sure that your IP is secure because a lot of times for businesses their intellectual property is what they have in order to ... That's their competitive advantage. Let's say that it's a patent, and let's say that they've gotten a patent and they have the ability to lock out larger competitors, and that makes them a more attractive target of potential acquisition. They want to make sure that they have the rights to the patents. The laws especially with patents have changed dramatically. In March of 2013 in fact there was the most significant revision to patent laws since 1952 that happened just a couple of years ago where the United States move to a first-to-file system as oppose to first–to-invent. And I talked a little bit about that.
But copyrights ... this comes up I can tell you if you're starting an online business and you get someone else to write code for you, the creator of the code by default has the copyrights. You could just get these really weird scenarios where you spend $40,000 hiring a programmer to get something off the ground. But even after you paid the $40,000 you don't own the copyright to the code that you paid to have developed. And it can absolutely be maddening from a legal perspective. And a lot of people say, "I don't want to talk to a lawyer. They're too expensive. I don't want to deal with it. I'm just going to roll on my own terms." I get the predilection to just go rogue on that regard because lawyers could be ridiculously expensive. And so I get why people are like just file all the legal doom and I'll put my name in and it's okay. Generally, I think that's a really bad idea because an experienced business lawyer can spot issues and tailor it specific to your scenario. But I will say I do get the pain point because lawyers are often times ridiculously expensive so I get why founders resort to these other documents that are just online.
I would say when it comes to this to combat this, is talk to a lawyer. A lot of times they'll meet with you the first time for free, there’s not a charge. But ask them about alternate fee arrangements because a lot of lawyers don't want to turn away the business. I had several startups work out these alternate fee arrangements with law firms. and I feel that's win-win scenario because it's not too much work on the part of a law firm or a lawyer, and the startups get exposure to the sophisticated legal advice. And when I say alternate fee arrangements it may be, "Hey, there's a small fee up front but when you raise a certain amount of money in around. Let's say you raised $100,000. Then that's contingent and then the rest your bill is due, or something like that. There's ways to get around it, and people just have this entrenched aversion to lawyers because they assume that the price is going to be ridiculously high. And I get that because a lot of times it is. But if you ask about those alternate fee arrangements it really open the door to a world of possibility.
You want to make sure that your IP is secure because a lot of times for businesses their intellectual property is what they have in order to ... That's their competitive advantage.
Jeff: Make a note of that or at least write it there in the margin if you're taking notes on this program. I'm talking with Annal Vyas. He is at the University of Akron School of Law in Akron, Ohio where he is a Visiting Professor of Clinical Law. And he himself an attorney, we're talking about the top 10 legal concerns that you as a small business owner need to be cognizant of, need to be aware of, and need to address. We’ve got to go to a break here in just a second Annal but let's go ahead real quickly before we do that and handle one more: trademarks. Everybody knows what they are. These are essentially the physical, graphic representation or face of your company, and a name, or a logo, or something like that. These are important to protect for a number of reasons.
Annal: Yeah, absolutely. A trademark protects someone from using a confusingly similar name to yours. For example I couldn't come up with Nike and spell it N-I-K-E-Y and start selling shoes and be like, “We're different from Nike the shoe company” because it creates a consumer would be confused to try to figure out whether my Nikey was the same as the Michael Jordan Nike. It's really important. The default rule for trademarks are that rights are based on you. So the more you use the mark the more rights in the mark because, again, it's all about preventing consumer confusion. Let's say that I open up a coffee store in Akron and I call it Binary Coffee, because binary is ones and zeroes, because a lot of people who code will go in coffee shops. I have rights in Akron, Ohio, but I don't have the rights in Cincinnati, Florida, or California, and someone could easily open up a Binary Coffee in California because, again, consumer wouldn't be confused.
So a lot of clients ask me, "How do I get that 50 States protection if I've only done business in one market?" And the answer is you can't file for a federal trademark registration which will give you 50 States protection, you do have to engage in interstate commerce. So make a sale across state line. For example in order to get that presumptive 50 State protection often times it's very much worth it especially if you're thinking about your brand going national. I don't want to get too far off topic, but I will say that with trademarks a lot of people ask me how do I come up with a name for my company? And a knowledge of trademark law absolutely can govern this discussion about how you come up with a name for your company. And so there's really four ... and I'll go through it very briefly. I found that a lot of startups want to know about this is that...
Let's say that I open up a pizza store and I just call the name of the pizza store Pizza. That's an extraordinarily stupid name. I can't get a trademark on that because I'm just describing what I'm selling. But let's say I changed the facts a little bit and that category one is Pizza for Pizza. Category two, let's say I changed the facts a little bit and I call my pizza shop Cheesy. Can I get a trademark on that? The default is no, but there's an exception that I'm not going to get into. Again, you're just describing what you're selling so it's not really good under the law for you to be granted this impermissible monopoly on preventing other people from using the word Cheesy in relation to pizza. There's another category where you – think of Ford Mustang. That's a little different from the first two examples that I gave you. Mustang for a car is suggestive in that it suggests some quality about the product that you're selling. A Mustang is fast and strong so hopefully you'll think that a Ford car is fast and strong. And the final category of marks is really 4a and 4b, 4a is an arbitrary mark if you just come up with something Apple for computers, there's no relation. If you make a word like Vrock that didn't exist before.
The general rule is that you can get trademark protection on categories three, 4a, and 4b, but you can't get trademark protection on categories one and two. And that is really important for startups. Because a lot of times startups want to name their company with something like descriptive. Let's say they have health app and they want to call their Health app like LoseWeight.com. They might have a lot of problems getting trademark protection on just Lose Weight because it's just describing or it's more like Pizza for pizza. That's another critical component that you should talk about when figuring out the name of the product or service that you're presenting to the public.
Jeff: There you go, we're discussing the legal top 10 list of things you need to address to reduce legal and financial exposure, and maintain the value of your company. I'm going to be back with Atty. Annal Vyas when Deal Talk resumes in just a moment.
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Jeff: Welcome back to Deal Talk, I'm Jeff Allen with my guest Annal Vyas. He's an attorney and visiting Professor of Clinical Law in the University of Akron School of Law in Akron, Ohio. We're talking about the top 10 legal concerns or issues every business needs to address or certainly be aware of. Annal, I want to thank you again for joining us today, very important conversation. We're looking now at item number five, patents. This is a really, really important thing that people have to be aware of, and particularly those in the area of manufacturing.
Annal: Absolutely. This really falls under the general ambit of intellectual property, but a patent is a limited monopoly to exclude others from using, selling, practicing whatever the invention is. And the law for patents have changed dramatically, we are now first-to-file system. So really the first person who filed at the patent office will have priority. Technically we're a first-to-file and/or publicly disclose. But really you can think of it as the first to file. Previously we were a first-to-invent system and so a lot of people were saying, ”Does that mess over the little guy?” because now these big companies can go ahead and they can file these patent applications and the small business owner might not be aware of it. So that's definitely a critical component to consider. With patents a lot of people say, "How can I get a patent? Can I get a patent on anything?" You can. There's a whole lot of things that you have to do to get a patent, but probably the biggest one is you have to pass the test called Obviousness. You can think of the Obviousness test as thinking let's say there's an inventor at the center of a room, that there's all relevant things to that invention on the wall. The question is would it be obvious for a person having skill in the arts to come up with the invention. So patents are critically important and I would definitely talk to a patent attorney.
the law for patents have changed dramatically, we are now first-to-file system.
Jeff: Next on the list, at-will versus contract employees, how to properly protect yourself against any kind of confusion concerning both at-will and contract employees.
Annal: These are some of the first ten things that came to my mind. I was thinking maybe I did a couple of these are the top ten. So I'm just saying that at-will, knowing the profit of at-will employment most States are what's called an At-Will Employment State meaning that you can let anyone go for any reason whatsoever. You don't have to have a reason. Again, I'll pick on the state of Michigan because I'm from Ohio. Someone walked into my office that I've hired and they have a University from Michigan tie I can fire them immediately because they exercised poor judgment wearing a Michigan tie. But actually, they don't even need to do that. I could just say, "You know what, I don't feel it today. I'm going to let you go." Obviously, there's certain things we can’t do. So if someone's part of a union for example you have to go through the collectively bargain situation or agreement. You can't fire someone based on a protected class like race, religion, that type of thing. But generally, with At-Will employment you can let anyone go for any reason. A lot of people feel that they need to have a contract with an employee. Sometimes contracts with employees and having employment contract absolutely worthwhile and you definitely need it. But a lot of people don't realize that the tremendous rights that employers have in those states and that they are an At-Will Employment state.
Jeff: This is one that comes up from time to time, employee versus independent contractor classification. You have companies have a problem with this in discerning between the two. This can be kind of a dicey situation.
Annal: This is huge, and the IRS is really cracking down on employee versus independent contractor misclassification. At a high level the reason why this matters is that if someone is classified as an employee then the employer has to pay withholdings, they have to pay certain employment taxes on behalf of that employee, and a lot of people just don't want to deal with the taxes. They say, "We're going to 1099 that person. They're going to be an independent contractor and we're going to not only 1099 them, I'm going to have them sign this form which says in writing that they're not an employee, they're an independent contractor, and I'm set.” They are absolutely not set and there's something that courts take this perverse pleasure out of tearing up a writing that says, "I'm an independent contractor not an employee." Courts don't really care so much what the party say the relationship is, they care what it actually is. And so how do you determine whether someone's an employee or an independent contractor? There's a bunch of tests promulgated by several different courts and agencies, but most of them all really come down to one word. And that word is control. How much control does the company have over the worker? Does the company exercise a lot of ... Is it telling the worker how to do their work? Are they telling them what hours to be at work? Are they providing the tools for the worker to complete the work? Do they have uniforms? How much discretion does the worker have? Or in contrast is it, "Hey, you're hiring someone who has specialized skill set who's coming in to help on a project by project basis", which is more indicative of an independent contractor relationship. You got to be really careful because you can be liable for back taxes, and penalties, and it can be an absolute nightmare. This is one of those issues that I've got front and center. Because so many startups say, "I'm just going to 1099 them, I'm not going to worry about them."
Uber is dealing with this right now in the courts. FedEx had a huge litigation treating their workers as whether they’re employees or independent contractors. So if you’re a small business owner, talk to a lawyer and get it right. And just don't have the person sign that form saying “I am an independent contractor”, because that's not really going to get you very far. And if anything it's going to lead to a sense of false security.
if you’re a small business owner, talk to a lawyer and get it right.
Jeff: Internet law is number eight, and terms and conditions for websites and a host of other things that kind of come into play here Annal.
There's privacy laws, there shine a light provision that you have to adhere to. There's data security issues. There's all sorts of things that come up that are really front and center in our digital age. If you're dealing with credit card information, that's always dicey. You got to make sure you're dealing with PCI compliant vendors. I'd strongly suggest talking with an attorney and a specialist about this.
Jeff: Two more to go on our list today Annal. Taxes, double taxation concepts of C-Corps versus pasture of an LLC. We could probably go into, again, this would be probably another great topic for another show altogether and just discuss this one item. But tax is another here in the top 10 list of legal things that businesses need to be concerned about.
Annal: Yeah, and I hit upon the difference a little bit between double taxation and pasture taxation, one level of taxation, earlier. But there's other tax issues. I was talking to a good friend of mine, one of my best friends, and I was telling him for years now, "You should think about making this S-Selection, there's something called the S-Selection and you're going to save on self-employment taxes." "We've never done it. I'm a small business. I'm fine." I was like, “You need to do this, this will be fantastic.” He did it and then he calls me up a couple of months later. He said, "By the way, you saved me $30,000 a year on taxes." And the S-Selection, a lot of people don't know about it, and they also think it’s only for corporations but an LLC absolutely can make an S-Selection.
And if you meet certain criteria, you get a break on self-employment taxes. And what those criteria, if you are a business that has 1-100 shareholders. You have one class of stock so you don't have common versus preferred. And you only have US citizens who are involved and none of the shareholders are another corporation or another entity, and those situations apply, a lot of those times those situations apply to small businesses. You can apply for the S-Selection and you can save money on self-employment tax. And a lot of times those taxes and savings could be significant.
And then another tax issue that comes up a lot is the 83(b) election which goes back to when you're doing that founder vesting that I was talking about. If there's a situation where you have vesting involved with a startup you always want to think about making the 83(b) election because you can certainly save money if the value of your shares appreciate.
Jeff: Annal Vyas we've got just a few moments left here in our program, and the tenth item on our list, consumer protection laws. Tell us a little bit about why these are so important.
Annal: They are important because a lot of times they're overlooked by not just startups but lawyers who are advising startups. There are a whole host of consumer protection statutes that people don't really realize or think about, which is another reason why it's really good to talk to a business lawyer. In Ohio for example we have something called the Home Solicitation Sales Act where if there's a contract that's signed in someone's home then the consumer has a three day cooling off period. And a lot of startups don't know about that. And not only that, the law mandates that you include in any contract language providing sort of a background on the notice cancellation and then giving all these consumer rights to, informing these consumers of their rights. Again, maybe it’s not top ten, these are the ones that I've described in this ten maybe aren’t the top ten, the first that came to my mind but then I thought about it. There's certainly others but this is certainly one that is overlooked a lot, it's overlooked tremendously. Again, if there's one take away from this and you don't listen to anything I say is talk to a lawyer and talk to them about alternate fee arrangement because they can help you with this type of legal issue.
They are important because a lot of times they're overlooked by not just startups but lawyers who are advising startups
Jeff: By the way, Annal Vyas, where can people learn a little bit more about you and find out what you've been up to and what you know in case they'd like to go through and find out if there are certain areas or aspects of the law that you may have some answers to some of their questions right off the top of mind?
Annal: Sure. Again, I'm licensed to practice in Ohio. But if you're just interested in learning more about me you can find me on Twitter annal_vyas. I'm on Twitter, you can Google me, and then I think you can find my faculty page on the University of Akron School of Law as well.
Jeff: Atty. Annal Vyas, he's also visiting Professor of Clinical Law at the University of Akron School Law. He's been our guest. Annal I want to thank you so much for joining us. We're going to have you back on again and we're going to take one of these ten items. It may not be the top ten, but one of these ten we're going to drill down a little bit more deeply and talk about some of these things in detail.
Annal: Thanks so much for having me.
Deal Talk has been presented by Morgan & Westfield, the nationwide leader in business sales and appraisals. If you're thinking about selling a business or buying one call Morgan & Westfield at 888-693-7834 or visit morganandwestfield.com. And for more valuable information and insight from our growing list of small business experts make sure to join us here on Deal Talk. I'm Jeff Allen. Thanks again for listening. We're going to talk to you again soon.