Founder Tax Issues

My colleague Susan Schalla and I have been making videos for Nick Hughes’ Founders Live Group, which are followed by AMA chat sessions.

In this video, we talk about tax issues for founders, primarily:

  1. The 83(b) election — when it applies; when it doesn’t; when it is due; etc.
  2. Qualified Small Business Stock considerations in choosing what type of business entity to form.

We hope you enjoy the video.

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Federal Research Tax Credits for Startups

Guest Post By Dan Wright

Federal Research Tax Credits

Is your business involved in creating intellectual property or process and product improvement? If so, you or your business may qualify for federal research tax credits.

Common Misconceptions

First, let’s clear up some myths about what business activity qualifies for the credit. Many people think of white coats and test tubes when they hear the word “research.” However, in this context, the definition is much broader than that.

Another common misconception is that the research, or resulting products, must be completely original to qualify. However, that is not generally the case. Instead, qualifying research very often involves research that results in a product or process that is only new to the business performing the research. That fact that similar products or research may already exist is not relevant to qualifying your business activity.

What is the Credit Based On?

The credit is a wage-based program, which you can calculate by identifying the wages paid to employees who perform qualified research activities. Amounts paid to outside consultants are also included in the credit at 65% of each qualifying dollar spent. In some cases, supplies that are consumed in the research process can also be included in the calculation.

Multiple methods of calculating the credit may be available. But in short, the credit available to the qualifying business activity equates to 6%-20% percent of the incremental research expenses. The exact percentage is determined by the elected applicable method.

Who Qualifies for the Credit?

Any business performing qualifying research can qualify for the benefit. Since the incentive is in the form of a tax “credit,” the business must have a tax liability to get a current cash benefit. It is not a refundable credit, but the portion of a credit that is not used in the year it is generated can be carried forward.

Since regular corporations are subject to federal tax, they can claim the credit. Businesses that are considered “pass-through” entities for federal income tax purposes, such as LLCs that have elected partnership status and corporations (or LLCs) that have elected S corporation status, pass the credit through to the owners of the entity.

What Qualifies as Research Activity?

Only business activity conducted in the U.S. qualifies. Further, the research activity must be  “technological in nature.” This means that it must involve a hard science, such as computer software; engineering; medical, biological, or physical research; or other similar science disciplines.

Additionally, “funded research” does not typically qualify. This means that if research activity is funded by an outside source, such as grants or customers, the arrangement must be carefully evaluated to determine if it qualifies. That said, the fact that the research is partially or wholly funded by third parties does not automatically disqualify the activity.

What Activities do not Qualify?

The rules specify which business activities are disqualified. These activities include:

  • Costs incurred once production of the component begins;
  • Adaptation of an existing component to a particular customer’s requirement or need;
  • Efficiency surveys;
  • Activity related to management function/technique;
  • Marketing research;
  • Advertising or promotions;
  • Routine data collection/testing to evaluate quality control;
  • Activity related to style, taste, cosmetic or seasonal design factors.

New  Opportunities that Apply to 2016 and Beyond

Alternative Minimum Tax (“AMT”) Offset

Until 2016, the credit could only be used to reduce a regular tax liability. Beginning in 2016, however, it can also be used to offset AMT liabilities. The AMT offset is only available to businesses with under $50 million in gross receipts. However, credits passing through from qualifying businesses can still apply to individual tax liabilities.

Payroll Tax Election

Beginning in 2016, qualified startup businesses can generate research credits. Qualified startup businesses include those that have not had “gross receipts” for more than 5 years (meaning, the five year test starts with the first year in which business had gross receipts), and have had gross receipts of less than $5 million in the claim year. Research credits can then be used to offset the employer’s portion of the FICA tax in the following year. It’s worth noting, however, that startups should consider the related party rules when applying the gross receipts tests.

Since many startup businesses don’t generate taxable income in the early years after formation, the credit program historically provided little, if any, immediate benefit. Now that the credit can be used to offset payroll taxes, the credit has real value for qualifying startups.

Questions?

If you would like help determining if your business activity qualifies for the research credit incentives, and/or determining an estimate of the benefit, please contact Dan Wright at dwright@clarknuber.com.

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Token Sales & The Risk Capital Test

By Evan Jensen and Joe Wallin and Jordan Rood

If you are considering token sales and selling blockchain tokens in the U.S., you not only have to worry about the U.S. federal securities laws (see the latest from the SEC here), but also the laws of each state within the U.S. in which you sell the tokens.

Token Sales

Worrying about both federal and state law is something that happens whenever you offer to issue a security unless the federal law specifically preempts the state securities laws. Specific federal exemption occurs in very limited circumstances.

For example, if you are selling tokens to California and Washington residents, you have to worry about California and Washington state securities laws.

An example of federal preemption occurs under Rule 506(b). If you sell securities to only accredited investors under Rule 506(b), state law is preempted except for the requirement to file a Form D and pay the filing fees in states in which you have investors that require the filing.

In general though, the state securities laws exist side by side with the federal law and you have to comply with both. For example, if you issue stock options you have to comply with both federal and state law.

It is possible a token will not be a security under the federal securities law, but will be a security under a particular state’s laws. This could make your coin offering, if you are considering one in which you sell coins to US residents, more difficult than you might expect.

What is the Risk Capital Test?

The risk capital test is a test some jurisdictions apply to determine whether in a particular transaction the instrument offered is a security. This test is different, and arguably more expansive, than the Howey test used by the SEC in its analysis finding that the DAO tokens qualified as securities. Further, each of the approximately 16 states that apply a risk capital analysis characterize it a bit differently, but there are common elements among them.

In Washington State, for example, the statutory definition of “security” includes this concept:

“investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture”

The Full Statutory Definition of Security in Washington State

Below is the full statutory definition of a security in Washington State, RCW 21.20.005(17)(a):

(17)(a) “Security” means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture; voting-trust certificate; certificate of deposit for a security; fractional undivided interest in an oil, gas, or mineral lease or in payments out of production under a lease, right, or royalty; charitable gift annuity; any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof; or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any security under this subsection. This subsection applies whether or not the security is evidenced by a written document.

Practical Application of the Risk Capital Test

If you are buying a blockchain token, you are investing money or other consideration into something. Are you investing it in the “risk capital” of a “venture with the expectation of some valuable benefit where you do not receive the right to exercise practical and actual control over the managerial decisions of the venture”?

It all depends on what the the terms of the token offering.

If the offering white paper tells you that you might expect some benefit from the increase in the value of the token being sold, does that mean the token is by definition a security under Washington law?

If you are buying a token for access to a computer network or software that doesn’t yet exist, or exists but only in an early state, and your capital is “at risk” because it is going to be used to further develop the software, then there is a risk that you are selling a security under state law, even if the token is not a security under federal law.

One of the most famous cases in this area involved a country club to be built with membership funds.

[As an aside: we thing it is interesting and illuminating from a socialogical point of view that 30 years ago we were talking about whether memberships to clubs were securities and now we are taking about whether blockchain tokens are securities]

In the old, somewhat famous case re golf club memberships, the promoters hadn’t built the club, but were selling memberships to build the club. The California Supreme Court held that this was a security under at risk test, even though the memberships only entitled the purchasers to use the club once it was built. They weren’t entitled to a share of the profits of the club.

The case is worth reading when thinking about what is a security under states law for states who have adopted the risk capital test.

The analogy with a blockchain token sale is quite clear- even if the token is a software access token, a utility token, etc., if it is being offered far in advance of the service, and the funds raised from the sale of the token are usedto build the service (the “club”) then the purchaser’s capital is in a sense being put at risk. And no matter how promising the project, arguably the person purchasing the token is in danger of never receiving the promised service. The valuable benefit, in such a case, would be the future service being provided, likely coupled with an increase in the value of the token as it changes from a future value to an immediate value. An access token being sold to raise money to build a software platform may be fine under the federal Howey test, but nevertheless certain states may consider it to be a security.

Contrast this with a token being offered where the service is immediately available. A software service might restrict usage using a permission/license token rather than a serial number, as is common with software products like Microsoft Office. Or perhaps a usage currency could provide a limited amount of access which is consumed when the user performs actions or acquires content.

Probably the easiest example of a type of token that could be sold that would not be a security would be a token that entitles you to play a video game that is already built. It is hard to see how that would be a security. It is no different than selling the rights to play a video game for cash. The service being provided is an entertainment software product, handed over immediately when the user purchases the token. This could take one of several different forms, such as the popular free-to-play model using a cryptocurrency instead of a platform-specific virtual currency (i.e. Riot Points, World of Tanks gold). It could be a token representing ownership of a digital game product, or DLC content within a game. Or, it could take the form of a token credit inserted to play a specific game once, in the fashion of an old-school arcade machine.

The important detail here is that in each of these cases the connection between the token and actually playing the game is immediate- the user is purchasing and receiving the product immediately, rather than an expectation of a future value as a consequence of a contribution of risk capital.

Still, what if a token features a mixture of characteristics? What if there are two or more types of tokens which are connected to one another or related to one another in some way- even if one of the tokens does not have an expectation of profit, perhaps a combination of tokens and/or smart contracts could create an expectation in the purchaser that a token will eventually return a profit. And how far in advance of the service being available is too far?

Again, the larger point to token issuers is—and this is somewhat of an understatement–issuing a token is not the easiest thing in the world to do, from a legal and regulatory compliance point of view. As a general takeaway, a simple tactic to avoid this “risk capital” issue is to just avoid issuing tokens to residents of those particular states applying the rule, but otherwise, structuring the tokens to reflect a (relatively) immediate consumable benefit, rather than a speculative future one, is a way to reduce the likelihood that tokens would be deemed securities under the risk capital test.
Disclaimer: This blog post is for information purposes only. It doesn’t constitute legal advice or the establishment of an attorney-client relationship. Always consult with counsel before attempting to sell anything that might be a security. 

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The Beauty of Utility Tokens

By Evan Jensen and Joe Wallin

One thing the SEC didn’t say anything about in its analysis of The DAO token offering last week was the place in the ecosystem for “utility tokens.”

This was bemoaned by at least one other legal commentator. As Trent Dykes’ said, it “seems unlikely that the SEC was unaware of the concept of utility tokens, yet it chose not to discuss that topic. We wished they had.” 

As opposed to a currency token, which is a token intended to serve as a store of value, or an application token, which is intended to serve as a tool for the monetization of a specific service or platform (perhaps as an app-specific currency), a utility token is something different altogether. 

Utility tokens are tokens intended to serve a very particular function, such as

  • tracking a particular piece of information, or representing the movement of an object as it passes through a supply chain, or
  • conferring a user a right or permission to perform a specific action on a platform or service. 

And even a quite mundane and simple utility token can acquire a growing wealth of functionality due to being decentralized, as many different people develop on top of it. 
Let us give you an example. Suppose a library wanted to use blockchain tokens to keep track of its books. 

The library could create a category of token for its books. Its users would be given a “library card” which would essentially be an address, if they didn’t already have one. When a patron of the library checked out a book, the library would transfer the token to that person. And when they returned the book, they could return the token as well. Assuming everyone transfers the tokens when called upon this system would work just fine, effectively replacing the library’s private database. And, if done properly this would replace not just one library, but potentially create a single global database for any libraries which choose to participate. 

But what if a user doesn’t return the token when their book is due to be returned? Or what if a user returned the token but not the book? How do would we handle this?

There are a number of different solutions. 

To actually implement most blockchain applications, some degree of application-specific work is required to hammer out the practical problems for each use case. Developers have to make it work in practice using the set of tools available on the blockchain- chiefly by writing smart contracts. 

A blockchain smart contract can be written to hold a token, rather than sending it to the user’s address directly where they will have exclusive control. So our scrappy developers could implement a “borrow” smart contract for holding library book tokens — when a user checks out a book, instead of going to the patron’s address, the token is temporarily held within a smart contract. 

This smart contract *could* be written to automatically return the token when the book is returned. And there are many use cases that would make sense to have this sort of function, such as an access credential token that should expire after a certain period of time. But the problem with this use case is that the physical book is still out there. In this case, returning the token alone does not help. 

Suppose instead the patron must supply an amount in escrow to the borrow smart contract, perhaps approximately equal to the price of one or two books, which when the user accrues late fees for failing to return the book, the smart contract will automatically draw down from. This would be synonymous with the fees many libraries currently charge to obtain a library card, and when depleted the user would be unable to borrow more books before replenishing it. 

If the person returns the book on time they will be able to borrow another one for free. But if they never return the book, then eventually the user will essentially have purchased the book, and the library is effectively forced to assume there is a possibility a book will never actually be returned. And they should structure their application and smart contract accordingly. 
At this early stage the library book token may not seem very useful. After all, existing library databases track who has which book all the time.
But blockchains have interesting features.

First is decentralization, which in this instance represents the collapsing of the distinction between a provider and a consumer. In other words, each user of this blockchain system for library books could be *either a patron or a library at the same time. *This could be set up to allow me as a user to transfer a book to someone else without it having to go back to the library.* *

Second, don’t forget, blockchains are public databases. This means that the information about which addresses have which tokens (books) is public information that anyone can view (the public information would just be the address; no one would know which books you had checked out unless they knew your address). In some use cases, this is a serious drawback, such as if privacy is important, but it can also be very useful. Perhaps you would like to check and see if a certain library has a copy of a certain book available before you go down and check it out. Or perhaps you would like to browse a list of all the books a library has on a website. Or maybe you’re a data aggregator interested in searching for macro trends in global book movement or reading patterns. Third parties can devise all manner of inventive applications for these systems. 

Third, smart contracts can be added which expand functionality, perhaps in ways that a system’s original creators never envisioned. Perhaps book publishers will see this large database of book possession and write their own smart contracts which offer their books for sale. They don’t need anyone’s permission to do this, but would need to convince users that their code is worthwhile for them to use. But if they are useful enough to be used, then those new developments become building blocks for still further development, becoming incorporated into other, larger or more sophisticated functions. 

In summary, utility tokens represent unique opportunities. Although there is clearly a need for greater supervision of investment-oriented activities regarding ICO’s, it is important not to overly generalize to all tokens, many of which may be primarily concerned with users and software in a service rather than raising money.

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Blockchain Tokens: The SEC’s Take

By Evan Jensen and Joe Wallin

On July 25, 2017, the SEC issued a number of important pronouncements with respect to initial coin offerings and blockchain tokens.

The SEC issued: (1) a press release; (2) an investigative report into The DAO coin offering; (3) a Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on The DAO; and (4) an Investor Bulletin on Coin Offerings.

These materials are important and good reading if you are curious about this area.

The take away for many casual observers has been that the SEC declared that blockchain tokens are securities.

But that is not what the SEC said.

The SEC said that a Blockchain token “may” be a security. But a Blockchain token is not necessarily a security. It depends on what the token does, and what the offeror of the token promises.

The SEC’s investigative report said:

“Accordingly, the Commissioner deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. federal securities laws may apply to various activities, including distributed ledger technology, depending on particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”

Clearly, if a token grants a right to share in the profits of the business — then the offeror of the token is selling a security under the U.S. securities laws.

In the Investor Bulletin, the SEC said:

“Depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offering or sold may be securities.”

The DAO token fell within the definition of a security for a number of reasons. For one, the SEC’s investigative report indicated that the intention of the offering was to “distribute the DAO’s anticipated earnings from the projects it funded.”

"the various promotional materials disseminated .... informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment."

The Definition of a Security Under US law

The SEC’s analysis of the DAO token or coin as a security is quoted below.

“Under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, a security includes “an investment contract.” See 15 U.S.C. §§ 77b-77c. An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”). This definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299 (emphasis added). The test “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Id. In analyzing whether something is a security, “form should be disregarded for substance,” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), “and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.” United Housing Found., 421 U.S. at 849.”

Using this definition, many types of blockchain projects and their respective tokens likely are not securities. For example, a token which confers a license with language to the effect of “the bearer of this token has my [the author’s] permission to copy a specific creative work” most likely is not a security, but rather is more analogous to a content license, similar to one which might be purchased from iTunes. By contrast, a token which promises a share of the profits of a company would clearly be classified as a security, since the purchaser of the token expects a profit from the efforts of the company selling the token.

Blockchains and tokens are capable of an incredibly broad, creative, and flexible range of functionality, far above and beyond solely investment vehicles. Blockchains can be used to store practically any form of data or record, and tokens used to track anything that is transferable, not just securities such as stock or other interests in business enterprises. For example, a venue such as a theater could use a smart contract to automate the sale of tickets, automatically generating a unique token for each seat in the venue for each showing, and sell tokens representing show tickets using an online platform. A ticket is a good example of a function that requires a token that is transferable, but should not be characterized as a security.

In short, although some crypto tokens are securities, not necessarily all crypto tokens are securities, requiring a careful analysis of the token, its function, and the promotional materials and representations made by its creator(s). And that is what is really the heart and crux of the matter.

You might also like these blog posts

https://www.theventurealley.com/2017/07/sec-on-tokens-seven-takeaways/

https://www.virtualcurrencyreport.com/2017/07/blockchain-and-digital-token-update-sec-releases-investigative-report-and-investor-bulletin/

Cryptocurrency Whitepapers

You can find a list of cryptocurrency whitepapers here.

Disclaimer

This blog is for informational purposes only, and is not legal advice. Always consult counsel if you are thinking about doing anything in this area.

 

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NYSE Entrepreneur’s Roadmap

NYSE Entrepreneur's Roadmap
We participated in the publication of this book, The NYSE Entrepreneur’s Roadmap.

The NYSE Entrepreneur’s Roadmap, from Concept to IPO

Founders will find this book helpful as they navigate their startup’s formation, financing, and ultimate liquidity.

Where You Can Find The Book

You can find the entire book at on the New York Stock Exchange’s website. The book is available to download in its entirety via pdf.

We contributed Chapter Four, Key Concerns in Drafting Organizational Documents, which is attached. NYSE Entrepreneur Ch 4 – Carney Badley

We hope you find it helpful!

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Cryptocurrency Whitepapers: A List

If you are looking for cryptocurrency whitepapers, we have put a together a list  from some of the largest transactions over the last two years.

Please help us and we will update this list as more come on line.

Cryptocurrency Whitepapers

If you are interested in more information about this, please don’t hesitate to contact Ashley Long or myself.

 

 

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A Good Day For Equity Crowdfunding

Yesterday was a good day for equity crowdfunding. Washington Governor Jay Inslee signed into law Washington HB 1593. This bill will make it easier for companies in Washington State to use Washington’s equity crowdfunding bill.

Gov. Jay Inslee signs House Bill No. 1593, April 25, 2017. Relating to simplifying small securities offerings.
Primary Sponsor: Brandon Vick

If you like, you can watch the bill signing ceremony.

Thank you Governor Inslee, Representatives Brandon Vick (R-Ridgefield) and Steve Kirby (D-Tacoma), Senator Joe Fain, Cyrus Habib, and everyone else who supported this effort.

HB 1593 will do the following:

  • Harmonize the Washington law with the new SEC rules, including Rule 147A. Rule 147A is a new stand alone exemption outside of Section 3(a)(11) and rule 147. Companies can use Rule 147A without the advertising restrictions that complicate Section 3(a)(11)/Rule 147 offerings.
  • Allow companies to use the Washington crowdfunding exemption without having to be incorporated in Washington State. Delaware corporations will be able to access the law.
  • Allow accredited investors to invest an unlimited amount of money, up to the cap of $1M during any 12-month period.
  • Not require public disclosure of executive officer and director compensation quarterly. Instead, companies will be required to make annual disclosure to their shareholders and the DFI.
  • Sell equity other than common stock and preferred stock. Convertible debt and convertible equity will be allowed.

The next step is for the DFI to propose rules. They will seek comment, and so if you are interested in the process, it would be great to have you submit comments on the rules. If you would like to do this, feel free to email me or call me and I can help you do that.

Re the regulatory improvements, I would like to see:

1) The DFI change the rules on what types of preferred stock preferences have to be included in preferred stock terms

2) Allow revenue loans for companies that are generating sufficient revenue to pay back investors.

3) Allow the exemption to be used to purchase income producing real estate investments.

All in all, I am really pleased with the amendments. The new Washington State equity crowdfunding bill will be relatively easy to use. The big hurdles for companies using it will be:

1) They will have to complete and file the Crowdfunding Form with the DFI.

2) Pay the $600 filing fee.

3) Have GAAP compliant financial statements.

4) Hire an escrow agent to hold the funds until the minimum to close has been satisfied.

Companies that get approved by the DFI will be able to raise up to $1M from both accredited investors and non-accredited investors like who live in Washington State. Advertising will be allowed, even advertising on the Internet that might cross state lines–as long as you still only accept funds from Washington State residents.

For Washington companies that would like to raise money from friends and family, some of whom might not be accredited, the Washington equity crowdfunding approach is a good one to consider.

 

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Term Sheets: Binding & Non-Binding

Guest post by Teresa Daggett

First, let’s get the terminology of term sheets out of the way. Whether the document that outlines your deal is called a “term sheet,” a “memorandum of understanding” or a “letter of intent,” these terms mean essentially the same thing. We will use “term sheet” in this article, but the other terms could easily be substituted. The differences between these three are merely stylistic.

Why a term sheet?

The decision makers for a business have decided to do a deal. The deal may be for one company to buy another company, or the sale of stock or promissory notes to investors, or for some other reason. For purposes of this article, we will assume that the term sheet is for the purchase of one business by another business. Once the parties have determined the major points of the deal, they ask their attorneys to draft a term sheet containing the key provisions that they have agreed on. Invariably, the attorneys will also raise questions about other provisions that the parties may want to add to the term sheet.

By drafting a term sheet, the parties can identify their major issues before committing time and money to due diligence and the far more extensive drafting involved in the definitive agreements. In addition to the provisions in the term sheet, the parties can identify “deal-breakers” and create momentum to move the deal along. Some or all of the provisions in the term sheet can be specified as “binding” or the entire term sheet can be “non-binding and for discussion purposes only.”

What are often “binding” terms in a substantially non-binding term sheet?

Exclusivity period. Our hypothetical buyer wants an exclusivity period during which the seller cannot entertain any other offers for its business. Our hypothetical seller thinks the buyer may not have the financial resources it claims in order to buy seller’s extremely (in its mind) valuable business, and therefore the seller does not want an exclusivity period. If our buyer is successful in its bid for an exclusivity period, this will typically be binding on the parties, and the seller will need to stop courting other potential buyers during the exclusivity period.

Confidentiality. Another term that is typically binding if included is the confidentiality of the term sheet, its terms, and the negotiations between the parties. We all know that a promise to keep something a secret is easily broken. However, the statement that the confidentiality provision is binding will put the parties on notice to keep this deal secret until the parties are ready to announce it. At a minimum, this provision sets up a moral obligation to keep the deal secret.

Fees and expenses. Often a term sheet will include the binding term that each party is responsible for its own fees and expenses prior to closing. Costs can include legal, accounting and investment banking fees and out-of-pocket expenses.

Conduct of the business. The business that is being purchased is not going to be worth much if the seller decides to sleep in every day and not conduct the business as usual. A commonly used binding provision is that “seller will conduct its business in the normal and ordinary course, consistent with prior practices.”

Bifurcate! If your term sheet has binding and non-binding provisions, be sure to be clear which are binding and which are not. Bifurcate the two types of provisions, or set out a provision that states that the term sheet is not binding except for Sections X, Y and Z.

What other provisions may be in a term sheet?

Type of transaction. Going back to our hypothetical seller and buyer, is the stock or partnership interest being sold? Alternatively, are only the assets being sold? If this is an asset sale, what assets are included and what are excluded? Be sure the term sheet clearly states what is being sold.

Price and payment terms. Price is one thing that is usually agreed on before the lawyers get involved. However, the payment terms may not have been decided yet. Will the seller get partial payment at closing and then carry a note? If so, what will the terms of the note be? If there is a note, will the buyer provide a personal guaranty? Will there be a holdback for certain contingencies? Or an escrow? How much of the deal consideration will be risk to secure the representations and warranties? How long will the representations and warranties last? Is there a minimum claim size (a basket), and does it tip? (A tipping basket is a minimum claim threshold that allows the buyer to recover from dollar zero of damages once the minimum has been surpassed; as opposed to a deductible.)

Treatment of outstanding stock options, warrants and convertible notes. If a corporation is being sold and the company has any of these types of securities outstanding, the parties should address how to treat these for the least disruption to the business.

Key employees. If there are one or more key employees, the buyer will want to be sure that they will stay with the company after the closing. The arrangement may include employment agreements, board seats, or stock options. Similarly, if there is a key employee who will not remain, will a severance payment and a noncompetition/nonsolicitation agreement be part of the deal?

Due diligence. The buyer needs to know what the seller’s business actually consists of. Likewise, the seller needs to know that the buyer has the financial wherewithal to pay. The due diligence provision of a term sheet will typically state that the parties will sign a mutual confidentiality agreement and then disclose “such documents and information as reasonably requested, so that each party can perform a full investigation of the other’s business and legal conditions.”

Noncompetition. The buyer may ask the seller to not compete with the buyer after the closing. If the seller is sailing off into retirement, this may not be a point of negotiation. On the other hand, if the seller wants to start a business that is similar – but not directly competing with its current business – the parties may be able to reach agreement on a somewhat narrow definition of noncompetition, either in terms of geography, length of time, or type of business.

How elaborate should the term sheet be? Term sheets do not have to be long, but it is a good idea not to avoid hard issues if addressing them later will be a disadvantage to you. In other words, it depends on whether you are the buyer or the seller. In our hypothetical sale of a business scenario, it would usually benefit the buyer to avoid saying in the term sheet how long the representations and warranties will last, and how long after the closing the seller may be liable, and for how much. But for the seller, these issues are critical. A seller does not want to put off negotiating these items until later in the deal, typically.

Can the term sheet be deemed to be binding – even if it does not say that it is?

This may be a tough call if either party has partially performed or the term sheet was so heavily negotiated and reads so much like a definitive agreement that the definitive agreement would be a mere formality. We generally recommend that the term sheet be more of an outline of the terms of the deal and not contain sentences such as “All warranties, representations, covenants and agreements, including indemnities and releases hereunder, made by Seller and Buyer shall be deemed and construed to be continuing warranties, representations, covenants and agreements which shall survive the Closing.”

The problem with a term sheet appearing too much like a definitive agreement is that, if challenged by one of the parties, a court may impose its own interpretation of commercially reasonable terms.

Aside from the terms that should be binding, to ensure that the remainder of your term sheet is non-binding, consider:

• The parties contemplate a later, formal agreement

• Use the term “prospective buyer”

• Make closing subject to financing and satisfactory due diligence

• Avoid the terms “will” and “shall”

• Avoid performance requirements before closing, as performance may give rise to a promissory estoppel claim

This article is not intended to be an exhaustive discourse on the subject of binding and non-binding provisions in a term sheet. Rather, we just want to highlight some things to consider when drafting your term sheets.

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Venture Capital Office Hours with Voyager Capital

UW students and faculty interested in startups can talk monthly, face-to-face, with a venture capital investor and startup attorney.  Randall Lucas of Voyager Capital and I hold open office hours the first Wednesday of each month at the University of Washington.

Who comes to see us?  A wide range, from skateboard-toting sophomores who have coded up an iPhone app, to senior researchers considering commercializing robotics technology, to rising seniors considering whether to work at a startup and what “stock options” are — all have come by to chat during open office hours.

You can find us at the Information School (Mary Gates Hall, iLounge 4th floor) from 10-11, and then at the Computer Science School (Allen Center, atrium) from 11-12. We do these typically on the first Wednesday of every month, while school is in session.  (If you want to talk during summer vacation, drop us a line and we’ll set something up.)

So, if you’d like to come see us, we will be there on Wednesday, March 1.  Happy to give you feedback on your startup ideas, guidance on thinking about intellectual property, or suggestions on raising capital — or just to hear what you’re excited about working on.

 

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