Illinois Employers Face A Recent Rash of Class Action Lawsuits Filed Under State Biometric Information Privacy Law

Illinois enacted its Biometric Information Privacy Act (“BIPA”) in 2008 to regulate, among other things, employer collection and use of employee biometric information.  Biometrics is defined as the measurement and analysis of physical and behavioral characteristics.  This analysis produces biometric identifiers that include things like fingerprints, iris or face scans, and voiceprints, all of which can be used in a variety of ways, including for security, timekeeping, and employer wellness programs.

Illinois is not the only state with a biometrics privacy law on its books, however, its version is considered the nation’s most stringent.  BIPA requires a business that collects and uses biometric data to protect the data in the same manner it protects other sensitive or confidential information; to establish data retention and destruction procedures, including temporal limitations of three years; to publish policies outlining its biometric data collection and use procedures; and to obtain prior, informed consent from any individuals from whom it plans to obtain and use biometric data.   The statute also requires  businesses to notify employees in the event of a data breach.

Protection of biometric data is viewed as critical because, unlike passwords comprised of letters, numbers, or typographical characters, biometric data is unique and cannot be replaced or updated in the event of a breach.  Technology now allows biometric data to be captured surreptitiously, such as recording a voice over the phone, or face mapping individuals in a crowd or through photographs, increasing the risk for its theft or unauthorized or at least, unknown, use.  In fact, these more furtive methods of collecting and using biometric data is what led to the filing of five BIPA class action lawsuits in 2015 – four against Facebook, and one against online photo website Shutterfly – that alleged these companies used facial recognition software to analyze online posts, but did not comply with BIPA’s consent or other procedural requirements.  These first lawsuits brought attention to the private right of action authorized under BIPA, which provides that any “aggrieved” person may sue and recover $1,000 for each negligent violation and $5,000 for each intentional or reckless violation, or, in both circumstances, actual damages if greater than the statutory damages.  Prevailing parties may also recover their attorneys’ fees and costs.

The plaintiffs’ employment bar recently has gotten seriously into the BIPA class action game; since August 2017, approximately 30 lawsuits have been filed in Cook County, Illinois (where Chicago is), alone.  These putative class actions have been filed against employers in many industries including gas stations, restaurants, and retail, and typically involve the employer’s use of fingerprint operated time clocks.  The cases allege that the defendant employers failed to obtain proper informed consent or fail to maintain and inform employees about policies on the company’s use, storage, and destruction of biometric data.  Many of these lawsuits also allege the employer companies have improperly shared employee biometric data with third-party time clock vendors, and some even name the vendor as a defendant.

In addition to the obvious cost of class action litigation, these suits present additional legal challenges because many aspects of BIPA remain untested.  For example, the statutory term “aggrieved” person leaves open the question whether a plaintiff must be able to prove actual harm in order to recover.  The U.S. District Court for the Northern District of Illinois and U.S. District Court for the Southern District of New York both have dismissed BIPA suits for lack of standing where the plaintiffs did not allege actual harm.  The latter case, Santana v. Take-Two Interactive Software, is currently before the United States Court of Appeals for the Second Circuit, which heard oral argument in October 2017, but has not yet issued its ruling.   Other aspects of BIPA also remain in flux – such as whether facial recognition through photography is biometric data, as defined under the statute, and what forms of consent are compliant.  On the other side, defendants are challenging the constitutionality of the damages provisions, arguing that their potentially disproportionate nature to any actual harm violates due process.  As these issues are flushed out under BIPA, they are certain to affect other states who have already enacted, or may seek to enact, laws regarding use of biometric data.

This post was written by Daniel B. Pasternak of Squire Patton Boggs (US) LLP., © Copyright 2017
For more Labor & Employment legal analysis go to The National Law Review 

Using Phantom Equity to Grow Your Business: Pros and Cons

phantom equityThis is the second article in a series examining when an entrepreneur should consider granting equity or equity-like interests in his or her company, and if so, how to properly structure that equity or equity-like grant.  To view the first article in this series, please click here.  Today’s topic: Phantom Equity.

Phantom Equity Overview

Phantom equity is an equity-like grant that is tied to the underlying value of a unit (if the company is an LLC) or a share of stock (if the company is a corporation) in the company. More often than not, phantom equity is granted pursuant to a phantom equity plan, with individual phantom equity agreements for each of the applicable employees/executives.  The individual phantom equity agreements will likely have some customized terms for each particular employee (number of units, vesting schedule, etc.), while other terms are usually standard across each of the phantom equity agreements (rights to certain payments, forfeiture upon termination, rights to certain information, etc.).

An example may be helpful.  Let’s assume there are 100 units issued and outstanding to the members of an LLC prior to creating the phantom equity.  Then, 10 “phantom units” are granted to key employees pursuant to a phantom equity plan.  The end result is that the phantom unit holders would receive an amount equal to 9.09% (10 units out 110 units total) of certain payments made to the real unitholders (the holders of the 100 units) of the company.  The key fact to remember is that these phantom units are not actual units of equity in the company, but they are counted as if they are actual units for purposes of certain payment or events of the company.

Vesting

Generally, phantom units or shares are not paid for by an employee, but instead vest over time in exchange for the employee continuing to work full-time at the company during such vesting period.  Typically, I see a one year cliff (from the first date of employment), then vesting in monthly or quarterly increments over the following two to four years.  The one year cliff (meaning, no vesting occurs during the first year of employment) is done to protect the company from granting phantom equity to employees that leave the company for whatever reason within their first year of employment.  Sometimes, an employee that is granted phantom equity will negotiate partial or accelerated vesting if the company terminates the employee “without cause.”  This is typically not granted by most companies, but every situation is unique and I have seen it negotiated and granted to a few individuals.

Eligible Payments

A phantom equity holder will be entitled to payments in connection with certain triggering events.  These triggering events will be set forth in either the phantom equity plan or in the phantom equity agreement.  There is great flexibility for a company in designing their own particular phantom equity plan and what payments the phantom equity holders participate in.

The most company-friendly plans only provide for a payment in the event of a change in control transaction (i.e. the sale of the company).  This means any dividends that flow to members or stockholders of the company (not otherwise in connection with a change of control transaction) will not be shared with the phantom equity holders.  For example, if a company has 100 shares issued and outstanding to its shareholders and 10 phantom shares issued to is phantom equity holders that do not have a right to participate in dividends, and the Company is going to dividend out $1,000,000, then the holder of each share of stock would receive $10,000 per share ($1,000,000 split amongst 100 shares), while the phantom shareholders (10 shares) would receive nothing.  If a phantom equity plan is structured this way, the clear message to the phantom equity holders is that they will only share in the success of the company if the company is ultimately sold.  Phantom equity holders should understand the risk that he or she may not work at the company when it is sold, and therefore it is likely that such phantom equity holder will not receive any benefit from the phantom equity.  This is because phantom equity is often contractually forfeited by the employee when he or she leaves the company.  This allows the company to issue new phantom equity to future hires without further diluting payments made to real equity holders.

Valuation Hurdle/Phantom Appreciation Rights

Another key feature typically found in phantom equity grants is the concept of a valuation hurdle, or what is sometimes referred to as a “phantom appreciation right.”  If a company has been in existence for a few months or longer, then the company likely has some ascertainable “fair market value” greater than zero.  Let’s assume that a company’s fair market value is determined to be $5,000,000, and this company now desires to grant phantom equity to certain employees.  If there is a valuation hurdle in the phantom equity plan or agreement, then the phantom equity holders only share in the value that is created (based on their phantom equity percentage) that is above $5,000,000.  Using this same example, let’s assume the company is sold three years later for $10,000,000 and there are 100 units of real equity issued and outstanding and 10 units of phantom equity.  In such example, the real equity holders (100 units) would receive all of the first $5,000,000 of proceeds from the sale, and then the next $5,000,000 would be split 90.91% to the real equity holders and 9.09% to the phantom equity holders (per the math at the beginning of this article).

No Ownership Rights/Control 

From the company’s perspective, it is important that the plan and/or phantom agreements very clearly spell out that phantom equity does not grant any rights to the holder that would be typically granted to a normal equity holder under law.  This provision should explicitly state that the phantom equity holder has no voting or decision making authority with respect to the company in connection with being granted phantom equity.  It should also limit the rights of the phantom equity holder to demand certain information (financial or otherwise) from the company.  Conversely, if you are the person being granted phantom equity, you should consider negotiating certain information rights into your phantom equity agreement.

Tax Implications

Whether phantom equity or phantom appreciation rights are being granted, the tax situation is generally the same for the company.  Generally, payments made by a company in connection with phantom equity or phantom appreciation rights are deductible by the company at the time the payment is made.  Regardless, always be sure to discuss the tax consequences with a tax advisor before granting phantom equity or phantom appreciation rights.

Conversely, and as a big disadvantage to the employee being granted phantom equity instead of real equity, payments received by phantom equity holders are taxed as ordinary income.  The difference between ordinary income and capital gains (which typically would apply to certain payments made to true equity owners) can add up to thousands (if not millions) of dollars of additional taxes paid by the employee if the company has a successful exit event.  However, in positive news for the recipient, no taxes should be due by the phantom equity holder upon his or her receipt of phantom equity.  With respect to true equity issuances, the recipient will likely owe tax on the fair market value of the equity received, unless such equity was actually purchased by the recipient for fair market value.

General Pros and Cons

There are a number of reasons phantom equity may make sense for a company as compared to other types of equity and equity-like plans.  Below are a few final points to think about as you decide whether or not phantom equity may be a viable option for your company:

Pros:

  • It allows certain key employees to share in the growth and success of the company while existing equity owners are not explicitly diluted and do not give up any control.

  • May serve as a golden handcuff to keep key executives from looking at other job opportunities.

  • Employees do not need to actually purchase the phantom equity; in other equity plans, the employees will likely need to purchase the equity at fair market value or have to pay tax on the fair market value of the equity that they receive.

  • There is a great deal of flexibility that can go into the phantom equity structure.  The phantom equity can mirror true equity almost completely (participate in dividends, etc.), or it can be very limited (participates only in a change of control event, with a valuation hurdle).

  • If structured correctly, phantom equity can easily be forfeited without penalty to the employer or the employee if the employee leaves the company.

            Cons:

  • If structured poorly it can lead to extremely bad results, including the permanent dilution of existing shareholders or unit holders, and/or the forced disclosure of sensitive information to individuals no longer working at the company.

  • May require a valuation of the company by an outside accounting or valuation firm.

  • May not be as attractive to a key employee because it is not real equity, and the company usually has the ability to terminate the employee and consequently extinguish the phantom equity.

  • 409A (deferred compensation) issues can add complexity to structuring and achieving the intended objectives of the company and the employee recipients.

Summary

When structured correctly, phantom equity is an excellent option for both companies and key employees.  As I like to tell clients, granting phantom equity is somewhat akin to dating before getting married – there are clear benefits to both the employee and employer in putting a phantom equity plan in place, but if it does not work out, both sides can walk away with minimal, if any, strings attached.

© Horwood Marcus & Berk Chartered 2015. All Rights Reserved.

Part Three: Tips and Considerations (#11 – 15) before Opening a Fitness Studio or Gym

This article is the third in a three part series on tips and considerations before opening a fitness studio or gym.  For the first article (Tips 1-5), please click here.  For the second article (Tips 6-10), please click here.   Here are tips 11 -15:

open sign, fitness studio, gym

11.  Promote Your Studio Cost-effectively.  Bad news: building a membership following always takes more time and effort than fitness owners would like.  Good news: social media platforms have made marketing for fitness facility easier than it has ever been.  One common theme I see among successful fitness brands and ventures that have started within the past 5-10 years is their fierce devotion to maintaining their online brand via Facebook, Twitter, Pinterest, Instagram, Yelp and other relevant social media sources.  Social media is a proven winner on announcing sales, discounts and other relevant deals for getting potential clients in the door.  Ideally, you should start creating your social media presence about 3 months prior to your grand opening.  One word of caution: be careful not to start your online presence too early – I have had friends follow brands/new gyms online for months waiting for the studio or gym to open, only to be constantly let down at the continued delays. This leads to bad feelings from prospective clients and should be avoided where possible.  

12. Carefully Weigh Your Financing Options (Debt vs. Equity).  Most owners need outside financial support when opening a gym or club facility.  This money can come in the form of equity (people who give you money in exchange for an ownership interest in your company) or debt (bank or other third party that gives you money that must be repaid with interest).  Many people opt to take debt, as they do not want to give up any ownership or control in the company.  However, in many cases, banks and other third party lenders will not lend to an entity with no historical financials.  In the near future, the Health and Fitness Blog will have a separate blog entry devoted specifically to this topic (debt vs. equity).  Another option to finance your business is to (carefully) explore equipment financing, which is discussed in Tip 14 below.  

13. Personal Guaranties (On Third Party Debt).  Many third party lenders (banks) will also require a personal guaranty.  A personal guaranty, if drafted correctly, will make the guarantor (person or people executing the document) personally liable for the company’s debts.  When possible, an owner of the company with significant personal assets should always resist signing the personal guaranty, or at the very minimum attempt to limit the total amount of the personal guaranty.  There are a variety of techniques and methods for negotiating down the scope of the guaranty depending on the lender’s appetite for risk.  

14. The “Easiest” Financing May Be the Most Costly.  Many new business owners get frustrated with the convoluted process and length of time it takes to obtain traditional bank financing, in addition to having to sign a personal guaranty (discussed in Tip 13 above).  An alternative source of financing sometimes comes from the equipment companies, which often have affiliated financing entities that lease or sell equipment to club fitness facilities.  Be aware that while it is generally easier to obtain financing from an equipment company affiliate, the penalties for non-payment may be swift and severe.  In most cases, if you miss a payment on purchased or leased equipment, the financing source will likely have the right to charge you a default interest rate of 15-20%, and after a certain period of time, the equipment will be seized from your location (without any refund for fees paid to date in the case of purchased equipment).  Be sure to read the financing agreement closely and find out the default interest rate and equipment seizure remedies, and consult with someone well-versed in finance if you are in over your head.

15. Start Small and Work Your Way Up.  Many entrepreneurs are resistant to opening their doors until everything is just right.  These owners want all the bells and whistles in their studio or club before they start getting traffic through the door.  My advice is to avoid following the mantra “go big or go home” when deciding how much equipment to initially purchase or lease, and what wish-list items you actually install in your studio or club facility before you open your doors.  From financial perspective, open machines = negative cash flows.  In the end, it is better to start small and, as your membership grows, add treadmills, ellipticals and other equipment assuming there is additional unused space.  Also, by starting small and seeing what works and what doesn’t work, you avoid giant expenditures that are big unused eyesores in your facility (double whammy).

© Horwood Marcus & Berk Chartered 2015. All Rights Reserved.

Part Two: Tips and Considerations (#6 – 10) before Opening a Fitness Studio or Gym

This article is the second in a three part series on tips and considerations before opening a fitness studio or gym.  For the first article Tips 1-5, please click here.  Without further ado, here are tips 6 – 10:

6. Location, location, location.  In my experience, poor location choice is the #1 mistake that people make when opening a fitness studio.  “Right” location consists of not only a great geographic location (i.e. high foot traffic, lots of public transportation and/or parking, ancillary businesses like Lululemon, but also the right cost per square foot.  The perfect geographic location is no longer perfect if the price per square foot is too high – especially in the first few months of operations.  Conversely, going a bit off the beaten path to secure a much cheaper cost per square foot is also crippling to a business.  You may have lower rent, but you will also have lower membership.  Working with a broker that is knowledgeable about fitness studios in the targeted area is highly recommended.  Remember, the broker is paid by the landlord, so this is virtually a free service for a prospective studio or gym owner.

7. Negotiate (do not just sign) your lease.  You have found the perfect location at a rent that works for your business model – GREAT.  The next step is the landlord (or their attorney) sending you its form Lease Agreement.  I have personally come across Lease Agreements for studios and gyms ranging from 6 pages all the way to 60 pages.  In sum, the form that is presented to you is going to be extremely one-sided in favor of the landlord and will likely need to be negotiated in a few key areas.  Some (but not all) of these key areas:

1.            Term: What is the initial term of the lease?
2.            Renewal: What are your renewal options?
3.            Rent Increases: Will the renewal terms be subject to rent increases?
4.            Condition of Space: What condition will the space be delivered in?
5.            Repairs: Who is responsible for repairs?
6.            Pass Through Expenses/Taxes: Who is responsible for these additional costs?
7.            Breach/Cure: If you breach the lease, do you get notice and time to fix?
8.            Use Provisions: Can you legally operate a gym in the space?
9.            Noise: How are noise issues and remediation options addressed in the lease?
10.          Personal Guaranty: Will the landlord require a personal guaranty?

Be sure to work with a competent attorney well-versed in leasing when reviewing and negotiating your lease.

8. Price your membership options in a way that sets your studio apart.  Get away from the mindset that you should be priced similarly with other studios in the area.  If you price like your geographic competitors (i.e. other studios charge $40-60/monthly and you price at $50/month), you are bound to get lost in the shuffle. Consumers, especially millennials, crave deals and new (disruptive) gym/studio membership pricing.  A great example of the changing dynamic of studio pricing can be seen through the business model of ClassPass, which has an easy to use app for your smartphone (more on ClassPass in Tip #10 below).  Millennials love variety and ClassPass caters to the segment of the population.  Another example is My Time Fitness in Chicago, which charges members a very low monthly fee and additional charges per daily use.  Be sure to brainstorm membership models that reward fitness and encourage members to participate in the studio or fitness community at your location.

9. Get the right kind of insurance.  Some types of insurance will be required to operate your business, while others are of the optional variety.   The hard part is determining what kinds and how much insurance to carry.  Some general categories of insurance to consider are the following:

1.            Property Insurance
2.            General Liability Insurance
3.            Crime Coverage
4.            Hired & Non-Owned Automobile
5.            Umbrella Liability Insurance
6.            Directors & Officers Liability
7.            Accident & Health Insurance
8.            Employment-related/Workers Compensation

Be sure to work with an insurance agent that is knowledgeable about the proper insurance required for the type of studio or facility you are operating.  Ask a potential insurance agent for a list of previous gym or studio clients that they have worked with, and be sure to call 1 or 2 of these clients to confirm they actually know the insurance agent and like working with him or her.

10. Run your business….like a business.  When starting a studio or a gym, it is completely natural to worry about whether or not people will actually show up and pay for a membership.  These feelings of worry often lead owners (especially first time gym and studio owners) to second guess the cost/value analysis of their membership pricing.  Owners tend to be scared of an empty gym and the message it sends to the paying members and general public, and consequently owners give away free 2 week or 1 month memberships to get people in the door.  While this is somewhat acceptable in the first month or two of operations as part of your opening marketing strategy, continuing to give away free memberships is not a sustainable business model.  Once people get something for free for an extended period of time, they often cannot bring themselves to pay for it when the free period ends.  Further, paying members will eventually leave the gym because non-paying members are taking up all of the spots in a group fitness class or on the treadmills.  Fitness Formula Clubs (FFC) in Chicago charges $20 for a daily pass; other gyms charge as much as $40/day.  People often balk at the cost to use the gym for just one day, since the monthly membership fee is generally $60-90/month.  However, when you are confident in your brand and pricing, there is no need to give things away.  To become confident in your pricing, be sure to conduct market research (i.e. talk to potential members about pricing and options).

An alternative and relatively new option for gym owners to consider is joining the ClassPass network (previously mentioned in Tip #8 above), which will increase your daily visit numbers while still being compensated for those visits.  For $79 – $99 a month (paid to ClassPass), ClassPass members get unlimited classes to dozens of studios in the ClassPass network. While ClassPass members can take as many classes per month as they would like, they can only visit the same studio up to 3 times per month. This allows potential new members to explore your gym or studio (while paying ClassPass), and if they like what they see, they may ultimately end their ClassPass membership and join your studio or gym directly.  If they do not end up joining your gym or studio, you will still receive a portion of the monthly membership proceeds from ClassPass.

© Horwood Marcus & Berk Chartered 2015. All Rights Reserved.

SAFEs and KISSes Poised to Be the Next Generation of Startup Financing

In late 2013, startup accelerator Y Combinator unveiled its Simple Agreement for Future Equity (“SAFE”) investment instrument as an alternative to convertible debt. While SAFE templates appeared in different varieties, the purported goal was to create a standardized set of basic funding terms between startups and investors while deferring decisions about valuation, liquidation preferences and participation rights until later-stage rounds of financing. In mid-2014, another accelerator, 500 Startups, introduced a competing document, dubbed the Keep It Simple Security (“KISS”). Although investors were initially nervous about accepting either of the new investment forms, these alternatives to conventional notes (“note-alternatives”) have become an increasingly popular tool for investing in early stage companies.

Note-Alternative Securities

Security instruments are contracts where companies take cash or other consideration in exchange for an equity interest in the company. Common stock is the most basic type of security and allows stockholders to manage the company generally on a one-vote-per-share basis. Preferred stock is similar to common stock except it grants its holders additional rights over and above the common shareholders such a preferred treatment at a set price in the event of a liquidation of the company. Options and warrants give their holders the ability to purchaseequity at a fixed price at a specified time in the future.

Unlike equity, convertible debt begins as a loan that the company is contractually obligated to repay, but may convert into equity such as preferred stock upon the occurrence of a specified event or events. Before conversion, convertible debt typically accrues interest and has a maturity date for repayment. As the maturity date for this type of debt approaches, illiquid companies may be faced with the paradoxical choice of renegotiating the instrument, seeking an alternative source of funding, or going out of business.

In a class of their own, note-alternatives are short and flexible security agreements that are designed to be simple to understand, negotiate, and administer. Note-alternatives combine many features of the more traditional types of securities and are designed to give investors and entrepreneurs the benefits of traditional securities while attempting to remove their major frustrations. Note-alternatives are contractual rights to purchase the company’s equity at a future date, similar to warrants, but the conversion price remains undetermined until a later date. Like convertible debt, note-alternatives are a quick and simple way of providing companies with cash in exchange for the promise of future equity. A major difference is that note-alternatives generally do not accrue interest and do not have stated maturity dates.

A note-alternative is an agreement that — when the company raises additional money, is sold or undergoes an IPO — the note-alternative will convert into an amount of preferred stock based on the value of the company as determined in the new round of financing. Although there are variations on the terms, most note-alternative securities convert into a special series of preferred (or “shadow preferred”) that has the same features as the company’s other preferred stock except for its conversion price, liquidation preference, and dividend rate.

A Typical terms that may vary include avaluation cap or anuncapped note alterative, discounts on conversion and the rights of the shadow preferred. Valuation caps and discounts are both pro-investor provisions. A valuation cap sets a maximum conversion price, and a discount gives early investors a percentage discount off of the valuation price.

Pros and Cons for the Company

Note-alternatives are short, simple agreements which makes them more readily understandable to entrepreneurs who are often not experts in law or finance. Note-alternatives typically do not accrue interest or have a maturity date, which reduces the risk of the company facing an insolvency problem. Sales of common stock by the company will not necessarily trigger the note-alternatives to convert, which gives the company added flexibility in its capital structure. Until the note-alternative converts into stock, note-alternative holders typically have no management rights and do not share in any dividends that are paid. But perhaps most importantly, note-alternatives are not treated as debt on the company’s balance sheetNote-alternatives are also likely to receive similar tax treatment as convertible notes, but investors and business owners should consult their tax professional for individualized advice.

Despite their benefits, note-alternatives can also have drawbacks from the company’s point of view. In particular, delaying valuation can be problematic for the company’s founders because note-alternatives with a valuation cap have essentially the same effect as a full ratchet anti-dilution provision and may act as a ceiling to the next financing round. If the company is valued significantly lower in a future financing round than when the note-alternatives were issued, holders of the note-alternatives will be entitled to take a much greater percentage ownership upon converting. It is also unclear whether companies that raise money using note-alternatives would need 409A valuations, which govern certain deferred compensation to paid service providers.

Pros and Cons for the Investor

If a note-alternative includes both a valuation cap and a discount, the company’s founders bear almost all pricing risk stemming from the agreement. If a later financing round is issued at a low price, the note-alternatives will convert into preferred shares based on that lower valuation, adjusted for any applicable discount. But if the later financing round is issued at a higher price, the note-alternatives will convert into preferred shares based on their own valuation cap, not the higher valuation of the financing. Also, because most angels and venture capitalists are in the business of investing and not lending, investors may find psychological appeal in using note-alternatives instead of convertible debt.

However, note-alternatives also have several drawbacks for investors. The note-alternatives typically have no maturity date, so investors are unable to declare a default. Although the underlying purpose of convertible notes is that they will convert to equity, convertible noteholders still have some minimal comfort that they can declare a default if the company fails to raise an equity round of financing or pay off the loans as they come due. Note-alternative holders, on the other hand, have essentially no rights until a financing or sale takes place.

Implications

Note-alternatives are an entirely different type of security instrument, not a mere offshoot from the familiar forms of financing structures, and some investors may see note-alternatives as being too favorable to the company and providing too little protection for themselves. As a result, investors will need to be flexible and willing to learn the nuances of these new instruments if they are to continue using them as a regular part of their investment strategy.

Authored by Stephanie L. Zeppa and Andrew S. Kreider of Sheppard Mullin Richter & Hampton LLP.

Copyright © 2015, Sheppard Mullin Richter & Hampton LLP.

Crowdfunding? Really? Crowdfunding Rule under the JOBS Act

Lewis Roca Rothgerber LLP

Count me a Luddite when it comes to social media in general, and more specifically, the supposed potential for crowdfunding and raising capital for start-ups and small businesses. My skepticism about crowdfunding admittedly has its roots in the resistance to public solicitation of non-public offerings that 20 years in state securities regulation embedded in me. Publicly solicited “private placements” before the advent of Rule 506(c) were all but certainly fraudulent. But, times (and exemptions) change.

Now, the word on the street is that the SEC has dragged its feet too long on promulgating its Congressionally mandated rule on crowdfunding under the JOBS Act, so the Republican House is going to take matters into its own hands and legislate a more rational crowdfunding exemption than the provision in the JOBS Act and proposed rule, without the need for SEC action. I can’t wait to see that hummer!

Since the subject of allowing crowdfunding for investments first arose in the initial rumblings that preceded the JOBS Act, there have been literally hundreds of articles, blogs and other commentaries tooting crowdfunding as the panacea for raising capital for start-ups and small businesses with the result that all sorts of new jobs would be created (a claim based more in hyperbole than empirical evidence.) Jobs? Perhaps some, but enough to make a national economic difference? Really? There has been at least one University of Colorado law review article on comparable legislation in Great Britain, and I have assisted a former securities law student of mine at the James E. Rogers College of Law, University of Arizona, in preparing her own article on crowdfunding that includes a review of British as well as other European capital raising crowdfunding regimes.

Most of these articles on crowdfunding appear to have been written by people who hope to profit providing services to general public crowdfunding principals once it’s lawful. A good share of them have been observations and opinions written by lawyers who regularly critique federal and state regulations, proposals and market developments. To one extent or another, the articles focus on Congress versus the SEC, or the needs for capital raising versus securities regulations.

These proselytizers and commentators have all but ignored what is truly the other side of the investment equation—the investors. I’m not talking about fraudsters. That dirty element will worm its way into whatever system is finally implemented, to one extent or another. I’m focusing here on the people who send their money to hopeful, legal crowdfunding issuers.

If the proponents of investment crowdfunding can run the “start-up businesses create jobs” pennant up the rhetorical flagpole, it’s only fair to allow me to hoist the “most start-up enterprises fail within five years” banner up right along next to it.

The unfortunate reality is that start-up businesses make horrible investments. Few of them survive at all, let alone turn a profit any time soon, let alone provide a return to investors. Investing in start-ups is like hunting ducks with a rifle, and few investors have enough “bullets” to fire.

Entrepreneurs are eternally enthusiastic, energetic and optimistic. They have to be. For many years, the dreamers (and their counsel) urged Congress and the SEC that “if only the ban on public solicitation and advertising were lifted, we could all fund our private placements.” Now that that cat is out of the bag with Rule 506(c), at least for accredited investors, the chant has shifted (predictably) to, “if only we could use crowdfunding to publicly solicit and advertise to reach non-accredited investors.”

If a start-up entrepreneur—I’ll call him “Fred”—is ready to turn to looking for funding from strangers, I think it fair to draw an inference or three about what has happened to date. First, Fred is tapped out on his own funds. Second, the bank has said or would say “no” to a loan, based on Fred’s lack of collateral or some other deficiency. Third, anyone Fred knows (and he may not know anyone) who might invest in his business—those people and businesses with whom he has a “pre-existing business or personal relationship”—have either invested as much as they are going to, or have found ways to be “on vacation in the Australian outback and hard to reach” when Fred has come calling for money the first time or for more later.

At this point, many entrepreneurs would keep working until they had saved up enough money of their own, or grew to qualify for that bank loan. A lot of business owners I’ve encountered have no interest in selling equity in their businesses to investors. But there are certainly those who are willing to do so. Whatever, at this point, “Fred” has now gone through all his own cash. His business and personal profile are insufficient to qualify for a bank loan, even if government subsidized. In other words, the professional lenders won’t touch him. Further, anyone who knows him and/or his business who might invest have either done so or won’t. With investment crowdfunding, Congress and several state legislatures and regulators have made the public policy decision to let Fred now turn to perfect strangers, the general public. So, the smallest, riskiest, least sophisticated, most poorly funded, most likely to fail business owners can turn now to the general public for investments when all the professionals and close-in people, those in the best position to know Fred and evaluate his company’s investment potential, have said “no” or “no more.”

To me, this is a public policy that makes no sense. If Congress wants to promote investment in start-ups and small businesses to create jobs, let them direct the Small Business Administration to ease their guarantee standards for SBA loans. Oh, we can’t do that because the SBA would go broke guaranteeing bad loans, thus requiring more federal funding? What’s wrong with this picture?

“Investing” in start-ups is akin to a parent “lending” money to her 24 year old. Good luck ever seeing that money again! At least she’ll get a Mother’s Day card. The non-investment crowdfunding successes to date have usually involved donors getting a sample product, a discount, or a souvenir tee shirt, baseball cap or the like in exchange for their donation. Perhaps Congress should take a hint from these crowdfunding success stories in fashioning its investment crowdfunding legislation, and mandate that investment crowdfunders distribute a commemorative sweatshirt along with their securities. That would at least give the investors something tangible to remember their investment by, and would create jobs by increasing demand for commemorative sweatshirts! Oh, wait, those are made in Malaysia.

ARTICLE BY

The Artist’s Legacy – Business and Legal Planning Issues

Sheppard Mullin Law Firm

Photographers face unique issues that must be carefully considered to ensure a continued market for the creative output and to preserve the artistic reputation. Prudently managed business affairs will minimize problems commonly encountered when closing down a studio and during the transition of business affairs from the photographer’s life to the photographer’s estate.

First, there is the issue of care for the physical works, the critical planning for the inventory, conservation and storage of the photographer’s works. Second is the issue of advantageously placing the photographer’s works; which works should be preserved, which donated, and when, where, how, including considering a sale or donation to a publicly-accessible archive as a permanent home for papers and other materials. This naturally leads to the third issue, prudent sales; how much and what part of the inventory should be released for sale each year and through what means? Is this the moment to re-examine the extant gallery relationship? These decisions require knowledge of the market, including a sense of timing, market conditions, and museum/collector interest.

Getting the house in order also includes appointing executors, attorneys, and accountants who can be trusted, who know the family or estate, who are familiar with and responsible toward the photographer’s work and the market, and who have both sensitivity and concern for the future of the photographer’s works and artistic reputation. Estate planning considerations for a photographer also include issues relevant for any individual: to provide for the surviving children, spouse and others according to the law and the photographer’s wishes so as to assure orderly transition and minimize the potential for probate litigation. For a photographer, though, preserving and enhancing a legacy also includes efficiently managing the estate to maintain continuity and safeguard the assets.

Photographers must likewise consider their intangible assets, which include copyrights, trademarks, licensing potential, and the like. It is important for photographers to register copyrights and keep track of any copyright renewal or termination rights, to be aware of current assignments and licenses of the intellectual property, and to maintain orderly files of subject releases, photographer agreements and other agreements affecting the works. Photographers should also consider licensing decisions to promote accessibility and generate revenue. It is crucial to weigh each transaction in terms of its potential for affecting the photographer’s stature in the art market. Indeed, one should consider the implications of each decision as it promotes and/or dilutes the overall value of the photographer’s oeuvre.

The photographer must identify and implement a comprehensive business and legal framework that can guide the present and govern the future in order to assure that legacy is preserved in accordance with the photographer’s wishes.

Above is the text of a handout on business and legal planning issues prepared by Christine Steiner. Christine Steiner and Lauren Liebes recently joined Weston Naef, Getty Photography Curator Emeritus, and ASA appraiser Jennifer Stoots for “What Will Become of Your Legacy”, a panel discussion at Los Angeles Center of Photography.  The panel addressed business and estate planning issues for photographers. In our next post, Lauren Liebes will address the myriad estate planning issues to consider.

ARTICLE BY

OF