A Mythical License to Blog

My friends at Philly Startup Leaders were burning up cyberspace last week with passionate posts to the listserv about an item that recently got picked up by blogs and conservative newspapers around the nation, as well as by the Philadelphia Inquirer. It seems that the city has contacted a number of Philly-based bloggers who reported marginal advertising income from their blogs on their federal income tax returns (we’re talking under $100 per year, folks, not the Huffington Post) to demand that they buy business privilege licenses and pay business (gross receipts and net income) taxes.

The licenses, which grant you the privilege to operate a business in the city and pay business privilege taxes (BPT), cost $300 (for a lifetime license) or $50/year. Since you need a city account number to pay BPT, and you can’t get one without a business privilege license, the city hits you twice, and you’re essentially buying the right to pay BPT (unlike in other cities which generously comp you the right to pay business taxes). Furthermore, as Councilman Bill Green acknowledged in a post to the PSL listserv, Philadelphia frequently doesn’t inform you of the $50/year option.

This was the most revealing part of Green’s post, most of which was a canned plug for a tax reform proposal put forward by him and Councilwoman Maria Quinones Sanchez, which they claim will favor Philly-based businesses over those headquartered outside the city by raising the threshold for payment of BPT, eliminating the net income portion of the tax and raising the level of the gross receipts component. (Mayor Nutter is studying the proposal.)

For me, the PSL discussion highlighted several core issues. First, let me be clear: legally, there is no new “blogger tax” or “blogger license.” You do NOT need a license to write a blog in Philadelphia, only to earn money from one. Our cash-strapped city simply applied existing business regulations in a ham-fisted manner, giving itself (as it often does) a very public black eye. (The same goes for Philadelphia’s Eliot Ness-style war on cupcake trucks.) Until PSL took up the issue, nobody seems to have thought much about whether bloggers are businesses or creative hobbyists, and what differentiates the two. (According to Councilman Green, the city is considering adopting an IRS-style test.)

Shaking down bloggers, confiscating cupcake trucks, and grabbing revenue from wherever it can are prime examples of the functioning of our Uncreative Economy, a closed world of special-interest groups, bureaucrats, politicos and tired and dwindling old industries. Is it any wonder that we are widely perceived as boorish and uncreative, not to mention hostile to business and entrepreneurship? Are you surprised that the intellectual capital nurtured at Penn, Drexel and Temple flees to New York, Austin, Boston and Silicon Valley and that the hallmark of a homegrown company’s success is leaving Philadelphia?

Unserious Entrepreneurs and Why It’s Better to Have Money Than to Not

A few of my fellow PSLers made two other points which I want to address. First, entrepreneurs derive real quality-of-life and economic benefits from having easy access to the thrumming social, cultural, intellectual and aesthetic infrastructure that is Philadelphia. Short commutes, the ability to ride the No. 48 bus to work (as I do every day), Buddakan being immediately downstairs from my office in Constitution Plaza, access to the creative and entrepreneurial ferment of Wharton, proximity to New York and D.C. without the astronomically high rents — aren’t these things worth $300 or $50/year?

Of course they are. But we’re already paying business taxes, among the highest in the nation, for these benefits. Hitting up entrepreneurs – or worse, hobbyists trying to eke out a few extra shekels in the midst of the worst downturn since the 1930’s — for an additional fee for the privilege of paying business taxes is clueless and disdainful.

Some PSLers also contended that $300 is not a lot of money, and that anyone unwilling to shell out such a nominal sum isn’t really serious about entrepreneurship and shouldn’t be in business in the first place. This is dead wrong, in my view. For one thing, it puts the aficionado who writes an opera blog out of sheer love for the art form and uses Google AdSense for aperitif money in the same category as Comcast or a rapid-growth tech startup that has just closed $20 million in venture financing.

Secondly, $300 is a lot of scratch even for a genuinely forward-looking startup. My clients fund their initial roll-outs from work income, severance and/or savings. In the evolving media space which is my professional ether, what puddles of funding exist must go toward development of the alpha and beta sites, branding, incorporation costs — and legal fees. Speaking of incorporation costs, I recently set a client up with a cheap Delaware registered agent ($99/year) rather than the standard national corporate service companies, who typically charge $275-$325 per year. The difference, $200 per year give or take, was significant to him.

This particular client told me he was sleeping on a friend’s floor to save money while the company was being set up. He is an extremely intelligent and focused entrepreneur with a nimble mind. You will not hear me call him a dilettante for wanting to save $200. That’s three or four hours of developer time, or an Amtrak ticket to attend an angel meeting.

Gargling Creative Capital

It is a privilege to build a business in Philadelphia. That’s why my office window looks out on the site of Ben Franklin’s house and I have woven (or my designer has) the street grid of Center City into my firm logo. A privilege, however, is not the same as a necessity. Nor is managing decline the same as leading. If the city doesn’t stop gargling its creative capital, those talented men and women will grab the first cupcake truck out of here.

I just wanted to share some thoughts on an issue critically relevant (although you may not know it) to all startups that are owned 50-50 by two partners. What happens if there is a deadlock, i.e., a failure to agree on some major business decision, that leads to a paralysis of the enterprise? In addition to the standard contractual buy-sell clauses (right of refusal for the other shareholders if a shareholder receives a third-party buyout offer, right to purchase a shareholder’s interest upon death, etc.), a well-drafted shareholders agreement or LLC operating agreement must provide an appropriate buy-sell mechanism permitting continuance of the business without costly litigation if a deadlock arises. In a nutshell, deal with it in the agreement, or else be prepared for everything to come to a screeching halt while you and your partner duke it out (with rhetoric, fists or lawyers).

Valuation, valuation, valuation

The crux of the issue, as it so often is with buy-sell clauses, is valuation. If a deadlock arises, the partners’ strategic visions have likely diverged, which in turn is likely to make it difficult to agree on what a 50% interest is worth. If a formula cannot be specified at the outset, one option is just to have both parties agree to recognize a fair price set by an independent valuator. If the parties cannot agree on a valuator, each could pick a valuator, the two valuators could pick a third valuator, and the final price could be determined by that valuator or by an averaging mechanism. The problem with this approach is that a valuation can be costly, particularly for digital media startups whose future earnings are highly speculative and which usually lack substantial brick-and-mortar or other easily valued assets. In such a case, the valuation process can eat up the financial assets of the partners and/or the enterprise.

Deadlock and the Texas shotgun

The “Texas shotgun” buy-sell clause is a flamboyant way of solving the valuation problem. Here’s how it works. The shareholders agreement or operating agreement defines a category of “Major Decisions,” such as selling, licensing or mortgaging a substantial portion of the company’s assets, entering into various types of strategic corporate transactions, changing the company’s accounting methods, starting a new line of business, etc. If the parties can’t come to a meeting of the minds on a Major Decision, then party A requests in writing that party B consent to the Major Decision. If party B refuses or doesn’t answer within a certain period of time, then a deadlock exists, and A can send a notice to B with a proposed purchase price for A’s shares. B then has the choice of either (1) buying A’s shares at the offered price, or (2) selling B’s shares to A at the purchase price specified in A’s notice.

The Texas shotgun mechanism is clean and brutally efficient. However, where one party (say, A) is in a much better financial position than the other (B), then an inequitable situation may arise where A can engineer a deadlock for the purpose of squeezing B out at an unfairly low price. To give a concrete example, let’s say A can afford to pay $100,000 for B’s 50% stake, but B only has the resources to pay $50,000 to buy A’s 50% stake. Let’s say the actual “fair price” for 50% of the shares is $75,000. A, knowing B’s financial position, declares a deadlock and sends B a notice offering to sell A’s shares for $55,000. But B can’t afford to pay $55,000 for A’s shares and therefore has to sell his own shares to A for $55,000, which is $20,000 less than the fair price for the shares.

Deterrence and punishment

The risk of a squeeze-out caused by a difference in financial resources can be limited through a “deterrence” or “punitive” clause. The idea here is to deter the wealthier party from declaring a deadlock. To give one example, the contract could provide that an independent valuator or valuators will determine the fair price of a 50% stake if a deadlock arises. Once the valuation is fixed, the party who sent the notice demanding the other party’s consent to a Major Decision must either (1) buy the other’s entire stake at 125% of the fair price, or (2) sell its stake to the other party at 75% of the fair price. While this approach remedies the inequity of the pure Texas shotgun mechanism, the downside is that problems tend to persist and fester.

To avoid continued paralysis and bad blood, the parties could agree on a Texas shotgun clause, but with the proviso that the price must be fair. If the less wealthy party felt he was being squeezed out an unfairly low price, he could demand a fair market valuation. Of course, this fallback essentially gives him two bites at the apple and could encourage him to be obstructive in decision-making, increasing the chance that a deadlock will occur.

Massaging the Texas shotgun

The parties could also combine the Texas shotgun approach with a deterrence component. For example, if the party with greater financial resources declares a deadlock and its offer turns out to be x% less than the fair market value determined by an independent valuator (with x% being more than some threshold percentage, such that FMV – x% is unfairly low), then that party would be required either to (a) buy out the less wealthy party at FMV + x%, or (b) sell to the less wealthy party at FMV – x%. To prevent the less wealthy party from exercising too much power, the parties might also consider stipulating in the agreement that if the less wealthy party demands a valuation which subsequently reveals the offered price to be within or above fair range, it will get punished somehow (for example, by being stuck with the cost of the valuation).

There are many different ways to skin (or shoot?) a cat. In addition to the valuation options discussed above, you can also partially level out wealth disparities by providing for buyer financing through a promissory note with a fixed interest rate or perhaps a rate tied to some benchmark rate. Make sure, however, that you talk about these issues and deal with them (particularly valuation) in your operating or shareholders agreement if you form a 50-50 startup with someone else. Everyone loves to get into the startup bed together, but — as with other types of human relationships, so with business partnerships — jumping out of bed in the harsh light of dawn can be an ugly experience. Especially with the barrel of a shotgun leveled at you.

Still, if a major part of your business is a website or software application (including iPhone and Facebook apps), it’s well worth the time and (minimal) expense to put in place at least a simple contract with your developers. This contract should get signed BEFORE the developer begins any substantial work on the project

What you get with a solid developer contract

Why do you need a properly written contract with your developer?

1. Confidentiality. Ideas have legs — muscular marathon runner’s legs — and you don’t want your developer to walk the idea for your new website or app across the street. It’s difficult to protect still-inchoate ideas and requirements (as opposed to completed designs, specifications or prototypes) under intellectual property law, since bare ideas in the process of formulation are not copyrightable or patentable. Moreover, the allowance rate for business method patents is extremely low (presently under 10%), and the cost of prosecuting patents is typically tens of thousands of dollars, so you should not count on being able to patent your website, program or app even at a more advanced stage of development. What this means is that, besides avoiding disclosures except where strictly necessary, contract protection (i.e., a non-disclosure or “NDA” clause) is your best bet to protect your idea as it is being developed.

2. Intellectual Property Ownership. Even if a bare idea is probably unprotectable, at some point the development of your idea is going to lead to the creation of protectable intellectual property. In the context of web or software development, this could be some or all of the following: (1) code, web design, graphics, images, text and other creative content (all of which can be copyrighted), (2) logos, slogans, catchy domain names and similar branding features (which can be trademarked), (3) look and feel (which is potentially protectable as trade dress), and (4) in rare cases, patentable inventions (if your site, program or app does something new, useful and non-obvious in light of the current state of the art).

It is a widely held but mistaken belief that if you pay a contractor to do something for you, you automatically own all IP rights in the work product because it is a “work made for hire.” (In fact, even attorneys often make this mistake, as I was reminded when I was a reviewing an IP asset purchase agreement drafted by opposing counsel the other day.) “Work made for hire” is a copyright concept only; furthermore, with outside contractors, it applies only to select types of specially commissioned works like atlases, parts of motion pictures or other audiovisual works, tests and instructional texts, which are generally irrelevant to the context we are discussing — and even then, a written agreement stating that the works are “made for hire” is still required!

In plain English, what all this boils down to is: you don’t own it (even if you paid for it) unless there is a contract that says you do. To be legally effective, the contract must also assign all relevant copyrights, patent rights and other IP to your startup. Without such a contract, you only get a license (i.e., a narrow right to use), the developer still owns any copyrights and patents, and it is free to use or commercialize this IP elsewhere. Potential investors and acquirors looking at your startup will want to see that you have IP ownership buttoned down. If you don’t own your product, watch out.

3. Getting What You’re Paying For. In development parlance, this refers to scope and specifications: you are paying X for the developer to build you Y, with Y being fleshed out in as much detail as possible in the contract. The importance of getting this nailed down is best illustrated by a common horror story: Client goes to Developer and asks Developer to build a site with A, B and C features and functionality. Developer says sure, no sweat; it’ll cost you $5,000, half up front and half on completion.

Developer labors for a month before realizing that he seriously underbid the project, which is far more complicated than he had considered. So he stops work and informs Client: sorry, I can’t possibly make a profit on this deal, but because I’m a warm-hearted stand-up guy, I’ll agree to just keep the $2,500 you’ve already paid, even though I’ve done $6,000 of work. For this largesse I welcome any comparisons to Gandhi you care to make. Client, who is out $2,500 and doesn’t have a website, is not inclined to award any Nobel Peace Prizes.

Developers may cry foul at this narrative. The common argument I hear from developers is that clients think developing a website is like rehabbing a bathroom, i.e., the client knows what it wants and parameters of the project are fixed at the outset, so there is no scope creep. In contrast, the argument continues, development clients actually DON’T know what they want. Their requirements are constantly in flux, and they require endless rounds of revisions.

Fair enough. But this doesn’t undermine the case for a contract. Quite the opposite, it means a contract is urgently needed by both parties to manage expectations. The contracting process is an opportunity for both sides to crystallize and refine those expectations before money is spent — what will the basic functionality/features be? what platform will the site run on? how many rounds of revisions are included? what will additional revisions cost? And so on.

The idea is that scope is reduced to writing as much as possible at the discussion stage instead of during the thick of development (and ideally a process is defined to handle any requested changes in scope). If it is impossible or impractical to draft detailed functional specifications at this stage, they can be a deliverable to be approved by the client later. (For complex or expensive sites or programs, the parties may end up splitting the risk by handling functional specification development and actual coding as two separate projects, each covered by its own scope definition and cost parameters, with the client having the option whether or not to proceed to stage 2.)

4. Getting It When You Need It. Launch is everything to startups. If a site or program isn’t ready or isn’t debugged by the time desired, this creates all sorts of risks — risk of the competition getting a jump on you, risk of seed capital running out, cash flow risk if an expected stream of revenue is postponed, reputational risk if you’ve heavily promoted the launch and then have nothing (or nothing respectable) to launch. A well-drafted development contract, therefore, should include key deliverable milestones along with delivery dates, and payments should be tied to successful achievement of these milestones in order to incentivize developer performance. A meaningful portion of the development fee (a third or more) should be payable only after final delivery and successful completion of user acceptance testing.

5. Legal Stuff. This is the part that startups really hate, but it can be critical if a dispute arises (as it frequently does). Say a Philly client hires a developer in California to build a site for $10,000. The parties sign a contract, and the developer takes the client’s up-front payment of $5,000. The developer then absolutely does nothing and greets the client’s increasingly anguished entreaties with an upraised middle finger.

It doesn’t take a tech lawyer like me to tell you the developer breached the contract. But how does the client left in the lurch get a remedy? The contract says nothing about where disputes will be litigated (venue) or which state’s law will apply to the interpretation and enforcement of the contract (choice of law). The answer is that the client hires a California litigator at $500/hr to fight over these issues, as well as over the underlying breach-of-contract issue, and after spending $100,000+ in legal fees (and traveling to California to testify), after three to five years the client may get its $5,000 back or perhaps a court order forcing the developer to finish the site.

Obviously this is a losing economic proposition for any client, and it would be insane to sue, despite the legal merits of the case. On the other hand, let’s say the contract had provided that the law of enforcement would be Pennsylvania’s, that any litigation must take place in Philadelphia, and that the party prevailing in any litigation would be entitled to be reimbursed for its legal fees, in addition to any recoverable damages. The costs and risks of enforcement are now working in the client’s favor; it can now bring the suit in Philly, representing itself pro se if necessary, and force the wrongful party (the developer) to pay both sides’ litigation costs, which is a big stick indeed. Of course, there may still be reasons why litigation is not advisable (for example, the client would still need to get a California court to enforce the Philly court’s judgment, and the developer may not have sufficient assets to pay the client’s legal fees and damages, which defeats the whole purpose). However, the client’s ability to raise at least a credible threat of litigation, together with the possibility of much higher costs for the developer, thoroughly changes the dynamics of the dispute and gives the client greater leverage.

Avoiding the 15-Page Monstrosity

If you think that adequately addressing these considerations requires a 15-page contract which would take months to negotiate and consume thousands of dollars in legal fees, you’d be wrong. All of this can be easily hammered out in relatively simple language taking up a couple of pages. Legal fees should be minimal if you’re dealing with an attorney who knows technology and is used to working with startups (otherwise, you may very well get the 15-page monstrosity).

Your startup doesn’t need a perfect agreement with every conceivable bell and whistle; the perfect should never become the enemy of the good. But the basic issues I have described need to be covered. It’s no exaggeration to say that the costs of not obtaining basic protection, in terms of both money paid out to developers and lost future opportunities for your startup, are likely to vastly exceed the legal fees.

And, developers — this is for your own good too. Think about helping your clients by creating a simple contract template with some moderated version of these basic protections for the client built in, along with protections against scope creep and whatever payment terms you need for your business. Contrary to popular belief, contracts aren’t just (or even primarily) for hypothetical future litigation — if drafted well, they are litigation-preventers and value-enhancers, allowing projects to glide to completion along a pathway of smoothly aligned expectations.

In my March 26 post “Guarding the Angels?”, I blogged about some troubling provisions in Senator Chris Dodd’s (D-Conn.) financial reform bill that would have subjected private offerings to angel investors to burdensome SEC review and state regulatory compliance obligations. Among other things, these provisions would have drastically raised the $200,000/year income and $1 million net worth thresholds for angels to qualify as “accredited investors,” which assures private offerings to such persons critical exemptions from federal and state securities laws.

No doubt this sounds like legal gobbledygook, but from the standpoint of a tech attorney whose practice is focused on aiding creative startups, the prospect was sobering. Since startup businesses, particularly in risky technology fields, generally do not have access to traditional bank financing, the addition of potentially tens or even hundreds of thousands of dollars in legal and compliance costs as well as 120 days or more of delay to the angel funding process could have devastated innovative startups and job creation at a time of 9.9% national unemployment. This was a classic case of our political aristocracy in Washington not having had the “Mommy, where do jobs come from?” conversation.

Fortunately, Senate Amendment 4056, approved by the Banking Committee on May 17, while not a perfect fix, largely vitiates the problematic anti-angel Sections 412 and 926 of the Dodd bill. For this we have to thank Senator Dodd himself, as well as Senators Scott Brown (R-MA), Maria Cantwell (D-WA), Mark Warner (D-VA), Kit Bond (R-MO) and Mark Begich (D-AK), although the real heroes were the startups themselves (including my colleagues in Philly Startup Leaders), who organized nationally to petition our elected representatives to remember our critical role in the economy at a time of worldwide economic crisis.

S.A. 4056 gets rid of the SEC review requirement and threat of exposure to state securities compliance requirements and keeps the accredited investor income and net worth thresholds fixed at their current levels for a period of four years, after which they will be subject to SEC review and possible adjustment. This eliminates the immediate danger to startup funding.

In their press release, the Senate sponsors of the amendment hit exactly the right note: whatever went wrong with Wall Street in 2008, startups and angel investors had nothing to do with it, so the government should lay off. However, at the same time it is disconcerting to realize how close we came to killing the goose the lays the golden eggs. Venture capitalists are few and highly selective; small angel investments are the primary vehicle for injecting seed capital into startups. How many future Googles, Facebooks and Microsofts might never have gotten off the ground? How much precious development money would have padded the pockets of securities lawyers? It seems that many senators were not even aware of the implications of their monstrosity. True regulatory reform requires transparency and patience for debate, as well as a willingness to forego dramatic political gestures in favor of targeted (i.e., boring) fixes that are narrowly tailored to diagnosable problems. Above all, it involves reading the freakin’ bill. Fortunately, our citizen-capitalists were on the ball.

Angel investors are wealthy individuals who purchase equity or convertible debt securities to contribute much-needed seed capital to startup businesses. Angel investors are different from venture capitalists (VC’s) in that they are individuals rather than professionally managed investment funds and typically invest much smaller sums of money (usually a couple of million dollars or less) than would interest VC’s. (Angels are also less demanding in terms of the economic and participatory rights of ownership, such as liquidation preferences, vesting of entrepreneurs’ equity stakes, seats on the board, etc.) With VC funding virtually non-existent due to the Great Recession, angel investments are the lifeblood for many struggling startups.

Sales of securities to wealthy angel investors normally come under the private placement exemptions to the Securities Act of 1933, which as a general matter requires filing of a registration statement with the Securities and Exchange Commission (SEC) prior to sale (a costly and onerous process). Under the safe harbor granted in Rule 506 of the SEC’s Regulation D (give yourself a pinch if your eyes start to glaze over at this point!), a company can sell securities in a private placement (i.e., without a general solicitation) to accredited investors and certain sophisticated non-accredited investors without filing a registration statement. Compliance with Rule 506 also enables the company to take advantage of exemptions from state securities laws (also known as “blue sky laws”), which otherwise can impose requirements in addition to those in the federal securities laws.

In the context of angels, an “accredited investor” is an individual with more than $1 million net worth or joint net worth with the individual’s spouse (alternatively, there are income tests for determining whether or not someone is an accredited investor). This makes sense in view of the overall purpose of securities regulation – angels are wealthy, savvy individuals who are used to investing, can afford good lawyers and business advisors, and frequently have a prior relationship with the founders of the companies in which they invest. For these reasons, they need less formal disclosure and regulatory protection than, say, a teacher who wants to put the money in her savings account into equities to get a higher rate of return.

Sections 926 and 412-13 of the proposed “Restoring American Financial Stability Act of 2010” would gut the current Rule 506 exemption by opening the door to greater SEC and state regulatory involvement in angel offerings:

• first, the rules would allow the SEC to designate certain securities offerings as not being “covered securities” under the 1933 Securities Act due to their small size (this would have the effect the effect of negating the Rule 506 exemptions from state blue sky laws and forcing companies to comply with differing requirements of individual states – e.g., filing and obtaining state review of a lengthy registration statement).

• third, the bill proposes to roughly double the net worth and income thresholds for accredited investors, meaning that fewer angel investments would qualify for the private placement exemption from SEC registration.

Needless to say, these requirements, if enacted into law, could have a huge impact on the flow of angel funds to cash-starved startups, disqualifying many transactions from favorable securities treatment and vastly increasing transaction time and costs (including legal fees). They could drive a stake through America’s still-beating entrepreneurial heart.

No one has a clear idea exactly how these provisions got into the financial reform bill, the ostensible purpose of which is to address the root causes of the financial collapse of 2008. While these causes are undoubtedly complex, I can safely say that angels run amok is not among them. From conversations with Senator Dodd’s staff, the best that inquirers have been able to discern is that the provisions were intended to deal with Bernie Madoff-type situations and hedge fund abuses. No one appears to have seriously considered the implications for angel investors and startups. Of course, this is an expected problem when, in the name of reform-at-any-cost, you ram through sweeping regulatory overhauls whose drafts consume legions of trees and no has the time to peruse in depth.

Fortunately, the entrepreneurial and angel community, especially the Angel Capital Association, was very much on the ball here, and, as we speak, their representatives are working with Senator Dodd and Senator Richard Shelby (R-Ala.) to make fixes. Hopefully we will have some good news to report on this blog soon. If access to angel funds is choked off, financial reform may turn out to be the “Jobs Prevention Act of 2010,” and we’re going to be enjoying 9.7% unemployment (or higher) for some time to come.

With a report released today showing unemployment in Philadelphia now at 11.4%, one thing we DON’T need is government guarding millionaire angels – from themselves.

On a legal note, one of the tidbits that VC’s have for startups is … make sure you have the proper intellectual property assignments in place with founders, employees and consultants (for my PANMA and PSL friends, that means: DEVELOPERS) to transfer ownership of all intellectual property rights to the startup entity. VC’s look for this when they do their due diligence for funding transactions, and you can bet your startup keister on the fact that everything will be given an even more penetrating once-over at the time of an exit event like an acquisition or IPO. If these assignments are not in place, your startup could end up being an unintentional co-owner of its product with someone else, who may be able to sell or license it independently as they see fit. In fact, I blogged about the need to nail down ownership last May, so you know how near and dear this issue is to my heart.

Someone else co-owning your patents or copyrights is NOT good for your valuation! If you need an IP audit or want to get IP ownership buttoned up, please give me a call. I always have time for startups.

A radiant weekend in the Old City

1. Entity Formation. Choice of entity is key. Find some sort of limited liability structure that gives you pass-through federal tax treatment (i.e., the entity’s income passes through to your personal tax return rather than being separately and duplicatively taxed). Either an LLC or an S Corp. would qualify. And don’t think you have to incorporate in Delaware. Pennsylvania has made a conscious effort to compete with Delaware for incorporations, and it’s really cheap and easy to form and maintain an entity here. The Pennsylvania Department of State Corporation Bureau has a website which allows you to check the availability of your desired business name and obtain the forms needed to start the business. It costs $125 to incorporate an LLC or corporation in Pennsylvania. Personally, due to the minimal registration fees, taxes and paperwork involved, I like the Pennsylvania LLC, assuming the business is headquartered here.

If you have or expect to admit partners into the business, you should have an LLC operating agreement addressing such issues as voting rights, management responsibilities, transferability of membership interests, allocation of income and losses, etc., but if it’s just you in the business for the time being, this is not critical. The bottom line is that for a small, relatively simple web startup, entity formation issues shouldn’t cost thousands of dollars in legal fees.

2. Trademarks. You or your attorney should do a quick trademark search in the searchable database on the U.S. Patent and Trademark Office website (go to www.uspto.gov and click on “Trademarks”) for the name of your business or website and any prominent catchphrase or slogan you plan to use on the site. What you are looking for are trademarks or applications for trademarks that are the same or similar to your mark and are used (or applied for) in connection with similar goods or services. This is a rough approximation of the legal standard for infringement of trademark rights (”likelihood of confusion” between two marks based on the two key factors cited above, as well as other factors like similarity of commercial impression, sophistication of target consumers, overlap of channels of trade, etc.). You should also run Google searches to identify similar terms and business names, since it is possible for another business to have “common law” trademark rights in a mark even if it isn’t federally registered.

The point of this exercise is to gain some comfort that you won’t be infringing someone else’s trademark, in which case you could be liable for damages (possibly treble damages and attorney’s fees for willful infringement) and would have to change your mark and/or domain name. The searches and analysis shouldn’t use more than a few hundred dollars of attorney time, unless the searches reveal a number of potentially problematic third-party marks and you want your attorney to investigate all of them in order to refine the risk assessment.

If a lot of money was being invested to develop a brand, you would want to perform a more rigorous (and expensive) search that would cover state trademark, business name and fictitious name registries, as well as additional “common law” sources like databases of publications, but this can cost thousands of dollars in attorney time and third-party search agency fees. A quick and dirty “knock-out” search of the type I have described should suffice for a small web startup without much seed capital.

You should also think about filing a trademark application to protect your rights in your mark against third party users, assuming that the searches of the USPTO trademark database and the Internet searches uncover no other marks that are confusingly similar, and that your mark is “distinctive,” i.e., is not a generic term for or descriptive of your goods or services. As of September 15, it will cost $375 to file a trademark application per class of goods or services ($325 if you file electronically), and each application should cost no more than $200 of attorney or paralegal time (excluding trademark search costs), unless you are applying for a lot of different goods or services. (To limit attorney and filing fees, talk to your attorney about what goods/services you should apply for now and what can wait.).

Of course, if the Trademark Office rejects your application, and you want your attorney to respond to their objections, this means more legal fees. If the Trademark Office is objecting to the mark itself (on descriptiveness or likelihood of confusion grounds, for example), rather than to some technical aspect of your application, the fees could run an extra grand or two, since your attorney will have to perform research and prepare a short brief. Having said that, you can always abandon the trademark application if it becomes too costly to proceed. Also, a good trademark attorney will be able to anticipate these types of objections at the search stage, so you should ask about your chances of actually obtaining a registration before you file the application.

You are not required to file a trademark application to use a trademark. You only need to do this if it’s important to scare off (by obtaining powerful legal remedies) third parties who may want to use the same or a similar mark. Investors will want you to register your key marks (such as your website name), but this is certainly not something that must be done prior to launch. If you decide to wait to file a trademark application, you should still make sure you place a TM (or SM for “service mark,” if you are offering services under the mark) superscript by the first prominent use of the mark on your homepage and in any marketing materials for the site.

3. Copyrights and Copyright Licenses. Website code, content and design are all copyrightable if they reflect a modicum of creativity and are not purely functional. Copyright comes into existence once a creative work is written down or recorded, i.e., you do not need to have a Copyright Office registration to own a copyright. Registration is necessary to exercise legal remedies against infringers, but again, this is something you don’t need to worry about right out of the gate.

What you do need to worry about right away is making sure you have the proper rights in all code and content used for your website. By “proper rights,” I mean owning the copyrights in materials designed or developed specifically for your site (HTML code, creative, look and feel, etc.), and suitably permissive license rights in third-party content (like clip art, stock photos and music) used on the site. With respect to the first category, specially created materials, keep in mind that the author (i.e., the programmer, web designer or web developer) owns the copyright unless he or she transfers it to you by written assignment. Therefore, without a signed development agreement or copyright assignment containing the necessary language, you get only a limited license to use developed materials, and the developer can do basically whatever they want with them or give them to someone else.

Do NOT, therefore, have someone design or develop a website for you without some sort of written contract. Investors will want to see that you own the copyrights in your site and have the documentation to prove it. The last thing you want to have happen, once your site becomes a success, is some third party come out of the woodwork claiming that they are entitled to royalties or demanding a right to consent to a planned sale, modification or exploitation of the site. An attorney can help you with this process. A simple copyright assignment should cost you $200 or less.

With respect to third-party content, make sure you read the license agreement to confirm that your planned use is within the scope of the license and there are no nasty surprises. (Of course, to do this you first need to make sure you HAVE the license agreement.) Don’t assume that because music or an image is lifted from a “stock” or “royalty free” source you can do whatever you want with it. For example, some “royalty free” licenses prohibit use of the licensed image for commercial websites or in promotional materials. You can take the first stab at looking at the agreement or agreements yourself, and bring in your attorney if you have questions. Make sure that any web developer or designer you use understands your concern about third-party licenses, and if you have a contract with them, the designer/developer should warrant that all content is either original or comes with license rights sufficient for you to operate and use the site for its intended purposes.

4. Other Contract Issues. Depending on how much you are willing to negotiate with your web developer or designer, you may also want to include additional safeguards in the contract such as business and functional requirements and specifications, acceptance criteria, milestones and deadlines, caps on fees, etc. If you are on a tight time schedule, think about negotiating a holdback of 1/3 or 1/2 of total fees until the website has been completed and you have verified there are no major outstanding issues. Again, this is not a legal requirement, just a good idea. A simple one or two page contract (which would include an assignment of copyrights) should not cost you more than a few hundred dollars in legal fees.

5. Website Terms of Use and Privacy Policy. If your website is in any way interactive, you should have legal terms of use and a privacy policy (indeed, the latter is required by the Federal Trade Commission and some states’ privacy laws if personally identifiable information such as name, address, e-mail address, Social Security or driver’s license number, and/or credit card or other account numbers are collected on the site). Contrary to popular opinion, not all terms of use and privacy policies are standard boilerplate.

With regard to terms of use, the legal risks and issues involved in a social networking site, a financial services site or an online store for power tools are going to differ from those for a passive site where users can coo adoringly over snapshots of puppies. In addition, a site that invites the submission of user content, such as blog posts, photos or videos, will need to have a Digital Millennium Copyright Act take-down policy to immunize the site operator from copyright infringement liability relating to content posted by third-party users. To be truly protective, the terms of use must be tailored to these risks and issues. Also, keep in mind that some legalese can scare website users (as Facebook learned to its chagrin earlier this year when its terms of use briefly stated that Facebook would own content that its users uploaded onto the site).

As for the privacy policy, you should think beforehand about (1) what types of personally identifiable information you will collect, (2) with what types of third parties (service providers, marketing partners?) this information may be shared, (3) what types of uses you foresee making of personally identifiable information, and (4) how, if at all, cookies, pixels and flash objects will be used on the site to collect information from users and how such information will be used and shared (e.g., will the information be shared with marketers or advertising networks for behavioral advertising?) Obviously, these decisions are partly cultural — how much comfort do you want to give your website users on privacy? If you have thought carefully about the specifics of your privacy regime (how information will be collected, used and shared) before having a conversation with your attorney, this will reduce your legal fees. If you plan to collect personally identifiable information from international users on your site, you should also bring this up with your attorney, since the European Union has much stricter privacy laws than the U.S.

Depending on the nature, features and complexity of your site, drafting the terms of use and privacy policy may mean spending anywhere from a few hundred to a few thousand dollars on legal fees. In my humble opinion — and I may be ducking rotten tomatoes from my fellow bar members for saying this! — it should not cost more than this, unless the site is extremely elaborate (Amazon) or the client extremely picayune. With that said, however, sites that offer highly regulated or controlled products or activities (such as online gambling, liquor, health supplements, contests or sweepstakes) or are targeted at children may also require additional disclosures (e.g., contest rules) or controls (e.g., a process to obtain parental consent for the collection of personal information from children under 13) beyond the terms of use and privacy policy, which, of course, will cost extra.

Painful as the legal fees may be, terms of use and privacy policies fall within the old adage, “An ounce of prevention is worth a pound of cure.” They are necessary shields against legal and regulatory liability. Additionally, with the FTC, in particular, sounding off on how certain behavioral tracking disclosures (among other things) should not be buried in legalese and also getting cranky about ways websites should notify their users about material changes in terms of use and privacy policies, you need to have these documents drafted by a pro.

6. Web Copy Review. Your attorney, who is probably thirsting for billable hours in these grim times, would love nothing better than to take a red pen to your site copy and etch out every conceivable source of risk. For most sites that are launched with little seed capital and do not feature heavily regulated or high-risk products or activities (gambling, liquor, financial services, sweepstakes or contests, material targeted to children, etc.), this is probably overkill. Having said that, it is a good idea to have a business lawyer with some experience in online promotions do a quick, high-level pass through the site to see if there are any major issues. For example, if you use certain terms like “Free” or “Guaranteed,” these carry with them special legal obligations and disclosure requirements. You also want your terms of use and privacy policy to be legally binding on your site users, so it is worthwhile to have an attorney eyeball the process or flow by which these documents are presented to and accepted by users.

To give yourself a reasonable degree of comfort, ask your attorney to spend an hour (but no more) clicking through the test site, and then see what he or she comes back with.

No doubt this quick checklist will provoke howls of outrage from some business lawyers who will note scores of issues that I have either glossed over (business structure and governance issues) or omitted entirely (patents, vesting of equity for partners who make service contributions). They are correct — this is not a comprehensive blueprint for launching a new business. If you have the legal budget for that, please give me a call. Please. My point is that if you’re just a small entrepreneur without angel investors or a powerful VC sugar daddy behind you and and you only have a couple of thousand dollars or less to spend on a lawyer, you need to know where you can get the most legal bang for your buck now, and what you can defer for a few months until the business starts to generate revenue.

Which is why I’ve discussed copyrights and trademarks (which are relatively cheap and are also easy for a web business to infringe unknowingly) but not patents (which, now that the golden age of business method patents is definitely over, are less relevant to ordinary web businesses; if you feel you’ve invented something really novel and useful, definitely raise the patenting issue with your attorney, but know that it can cost tens of thousands of dollars in legal and filing fees to apply for a patent, and, in any case, you have up to a year from your first public disclosure or commercialization of the invention to file your patent application). I could give you other examples, but you get the picture.

One additional disclaimer (of course, we love disclaimers!): the figures and ranges I have given above for attorney fees represent my opinion of what these various services should cost, not necessarily what an actual firm will charge you. They are ballpark estimates to help you decide what services are most important to you and fit within your budget. Hopefully they will also facilitate a fruitful conversation with your attorney about managing costs. If you do not have this conversation at the outset, do not be surprised if you do end up getting charged a lot more.

Consulting a good business and e-commerce lawyer is a necessary part of launching a web business. Like any other professional, we have a suite of services we want to sell you. All are useful, but they need to be prioritized. A good business lawyer will do this for you, but sometimes you have to ask.