Tag Archives: crowdfunding

Blockchain Is A Technology, Not A Philosophy

John Barlow died last Wednesday. Mr. Barlow wrote lyrics for the Grateful Dead, dabbled in Republican politics in Wyoming, and, more famously, had big dreams for the internet. He referred to the internet as “the new home of the mind” and demanded of governments, “I declare the global social space we are building to be naturally independent of the tyrannies you seek to impose on us.”

Good things have come from the internet, no question, but for the most part Mr. Barlow’s dreams have not materialized. Twenty five years later, the internet means mainly Facebook and Google for most people, along with a loss of privacy, e.g., Equifax. The internet has made it easier to work from home and collaborate and start social movements like #MeToo and #TeaParty, but also allows Russia to interfere with our elections. We’re connected all the time, yet somehow feel more lonely. And all the information circling the globe leaves us with a citizenry somehow less informed than when television came in three black and white channels.

Mixed results are not unique to the internet. Pick any technology – electricity, automobiles, television, nuclear power – and you’ll find the same story of idealistic dreams transformed or broken on the shoals of the real world. We imperfect human beings keep asking technology to save us from ourselves, and it never can.

Which brings us to blockchain.

Speaking at a crypto-conference in New York the day Mr. Barlow died, I heard a speaker predict that blockchain would replace the banking system, that cryptocurrency would eliminate national currencies, that we are about to witness a fundamental change (for the good) in the human condition. You can read articles in serious business publications about the “ethos” of blockchain, how the technology will replace our broken trust in private and government institutions.

In my opinion that thinking isn’t just wrong but dangerous. Blockchain is not going to replace the banking system, and shouldn’t. Cryptocurrencies will replace fiat currencies only in countries without a functioning currency of their own. If you see a country where Bitcoin is the currency of choice, it’s like seeing a guy on the subway with an IV in his arm:  you’re not sure what’s wrong, but you know he’s sick.

If you think blockchain has an ethos, you’ll sell tokens without bothering about securities laws. You’ll encourage wage-earners to invest their savings in a cryptocurrency whose price chart makes Pets.com look stable, having decided that it’s not so much a “currency” as a “store of value.” Most dangerous, you’ll convince yourself that technology is a substitute for morality.

Like every technology, starting with fire, blockchain can improve the human condition only if we tether it to our needs.

Fortunately, based on what I saw at the conference on Wednesday, there’s a lot of tethering along with the hype. Among other things, we heard from entrepreneurs using blockchain technology to:

  • Improve healthcare outcomes
  • Give consumers control over their financial records
  • Facilitate business and consumer payments
  • Reduce fraud in the financial markets
  • Make sense of our antiquated system of property ownership

With the grandiose predictions and the mystification and, frankly, some wishful thinking by lawyers, the blockchain industry has earned a black eye in the minds of many, including government regulators. Even so, light shines through. As an industry, let’s dedicate ourselves to using the technology wisely, making it work for ordinary people, being more transparent than the law requires, thinking long-term, and above all, remembering that how blockchain is viewed 25 years from now depends not on technology, but on imperfect human beings like us.

Questions? Let me know.

Using “Finders” To Sell Securities, Including Tokens

Selling securities is hard, and it makes perfect sense that an issuer or a portal would hire someone to help. And once you’ve hired someone, it also makes perfect sense business-wise to pay her a percentage of what she raises, aligning her interests with yours.

It’s perfect, but it might be illegal.

The Legal Issue

The Securities Exchange Act of 1934 generally makes it illegal for any “broker” to sell securities unless she’s registered with the SEC. The Exchange Act defines the term “broker” to mean “any person engaged in the business of effecting transactions in securities for the account of others.” That’s not a very helpful definition, but if you earn a commission from selling securities, like the helper above, you might be a broker.

So what? Well, if someone who’s a “broker” sells securities without registering with the SEC, lots of bad things can happen:

  • All the investors in the offering could have a right of to get their money back, and that right could be enforceable against the principals of the issuer.
  • The issuer could lose its exemption, g., its exemption under Regulation D.
  • By violating the securities laws, the issuer and its principals could become “bad actors,” ineligible to sell securities in the future.
  • The issuer could be liable for “aiding and abetting” a violation of the securities laws.
  • The issuer could be liable under state blue sky laws.
  • The person acting as the unregistered broker could also face serious consequences, including sanctions from the SEC and lawsuits from its customers.

What is a Broker?

Because the Exchange Act does not define what it means to be “engaged in the business of effecting transactions in securities,” the SEC and the courts have typically relied on a variety of factors, including whether the person:

  • Is employed by the issuer
  • Receives a commission rather than a salary
  • Sells securities for others
  • Participates in negotiations between the issuer and an investor, g., helps with sales presentations
  • Provides advice on the merits of the investment
  • Actively (rather than passively) finds investors

More recently, in court cases and in responses to requests for no-action letters, the SEC seems to be moving toward a more aggressive position:  that if a person receives a commission she’s a broker and must be registered as such, end of story.

So far, courts are rejecting the SEC’s hard-line approach. In a 2011 case called SEC v. Kramer, the court stated:

[T]he Commission’s proposed single-factor “transaction-based compensation” test for broker activity (i.e., a person ‘engaged in the business of effecting transactions in securities for the accounts of others’) is an inaccurate statement of the law. . . . . an array of factors determine the presence of broker activity. In the absence of a statutory definition enunciating otherwise, the test for broker activity must remain cogent, multi-faceted, and controlled by the Exchange Act.

As reassuring as that statement sounds, it was made by a District Court, not a Court of Appeals and certainly not the Supreme Court. A District Court in a different part of the country might take the SEC’s side instead.

But I Know Someone Who. . . .

Yes, I know. There are lots of people out there selling securities, including tokens that are securities, and receiving commissions, and nothing bad happens to them.

There are so many of these people we have a name for them:  Finders. The securities industry, at least at the level of private placements, is permeated by Finders. I had a conversation with a guy who offered to raise money for my issuer client in exchange for a commission, and when I mentioned the Exchange Act he said “What are you talking about? I’ve been doing this for 25 years!”

I’m sure he has. The SEC would never say so publicly, but the reality is that where broker-dealer laws are concerned there are two worlds:  one, the world of large or public deals, where the SEC demands strict compliance; and the world of small, private deals, where the SEC looks the other way.

In my opinion, Crowdfunding offerings and ICOs fall in the “large or public deals” category, even though it’s hard to tell a Crowdfunding client they can’t do something the guy down the street is doing.

So What Can I Do?

If you’re selling securities in a Crowdfunding offering or an ICO, don’t hire that person who promises to go out and find investors in exchange for a commission, unless she’s a registered broker.

On the other hand, in an isolated case, if you know someone with five wealthy friends, who promises to introduce you to those friends, without participating in any sales presentations, you might be willing to offer a commission, relying on current law, as long as (1) you understand that a court might hold against you, adopting the SEC’s hard-line approach; and (2) you hire a securities lawyer to draft the contract.

The Future

Several years ago the SEC created an exemption for Finders in the mergers & acquisitions area. I am far from alone in suggesting that we need a similar exemption for Finders in non-public offerings. The current situation, where a substantial part of the securities industry operates in a legal Twilight Zone, is not tenable as online capital raising becomes the norm rather than the exception.

Questions? Let me know.

The New 20% Deduction in Crowdfunding Transactions

Taxes and Income - iStock-172441475 - small.jpg

Co-Authored By: Steve Poulathas & Mark Roderick

The new tax law added section 199A to the Internal Revenue Code, providing for a 20% deduction against some kinds of business income. Section 199A immediately assumes a place among the most complicated provisions in the Code, which is saying something.

I’m going to summarize just one piece of section 199A: how the deduction works for income recognized through a limited liability company or other pass-through entity. That means I’m not going to talk about lots of important things, including:

  • Dividends from REITS
  • Income from service businesses
  • Dividends from certain publicly-traded partnerships
  • Dividends from certain cooperatives
  • Non-U.S. income
  • Short taxable years
  • Limitations based on net capital gains

Where the Deduction Does and Doesn’t Help

Section 199A allows a deduction against an individual investor’s share of the taxable income generated by the entity. The calculation is done on an entity-by-entity basis.

That means you can’t use a deduction from one entity against income from a different entity. It also means that the deduction is valuable only if the entity itself is generating taxable income.

That’s important because most Crowdfunding investments and ICOs, whether for real estate projects or startups, don’t generate taxable income. Most real estate projects produce losses in the early years because of depreciation deductions, while most startups generate losses in the early years because, well, because they’re startups.

The section 199A deduction also doesn’t apply to income from capital gains, interest income, or dividends income. It applies only to ordinary business income, including rental income*. Thus, when the real estate project is sold or the startup achieves its exit, section 199A doesn’t provide any relief.

Finally, the deduction is available only to individuals and other pass-through entities, not to C corporations.

*Earlier drafts of section 199A didn’t include rental income. At the last minute rental income was included and Senator Bob Corker, who happens to own a lot of rental property, switched his vote from No to Yes. Go figure.

The Calculation

General Rule

The general rule is that the investor is entitled to deduct 20% of his income from the pass-through entity. Simple.

Deduction Limits

Alas, the 20% deduction is subject to limitations, which I refer to as the Deduction Limits. Specifically, the investor’s nominal 20% deduction cannot exceed the greater of:

  • The investor’s share of 50% of the wages paid by the entity; or
  • The sum of:
    • The investor’s share of 25% of the wages paid by the entity; plus
    • The investor’s share of 2.5% of the cost of the entity’s depreciable property.

Each of those clauses is subject to special rules and defined terms. For purposes of this summary, I’ll point out three things:

  • The term “wages” means W-2 wages, to employees. It doesn’t include amounts paid to independent contractors and reported on a Form 1099.
  • The cost of the entity’s depreciable property means just that: the cost of the property, not its tax basis, which is reduced by depreciation deductions.
  • Land is not depreciable property.
  • Once an asset reaches the end of its depreciable useful life or 10 years, whichever is later, you stop counting it. That means the “regular” useful life, not the accelerated life used to actually depreciate it.

Exception Based on Income

The nominal deduction and the Deduction Limits are not the end of the story.

If the investor’s personal taxable income is less than $157,500 ($315,000 for a married couple filing a joint return), then the Deduction Limits don’t apply and he can just deduct the flat 20%. And if his personal taxable income is less than $207,500 ($415,000 on a joint return) then the Deduction Limits are, in effect, phased out, depending on where in the spectrum his taxable income falls.

Those dollar limits are indexed for inflation.

ABC, LLC and XYZ, LLC

Bill Smith owns equity interests in two limited liability companies: a 3% interest in ABC, LLC; and a 2% interest in XYZ, LLC. Both generate taxable income. Bill’s share of the taxable income of ABC is $100 and his share of the taxable income of XYZ is $150.

ABC owns an older apartment building, while XYZ owns a string of restaurants.

Like most real estate companies, ABC doesn’t pay any wages as such. Instead, it pays a related management company, Manager, LLC, $500 per year as an independent contractor. All of its personal property has been fully depreciated. Its depreciable real estate, including all the additions and renovations over the years, cost $20,000.

Restaurants pay lots of wages but don’t have much in the way of depreciable assets (I’m assuming XYZ leases its premises). XYZ paid $3,000 of wages and has $1,000 of depreciable assets, but half those assets are older than 10 years and beyond their depreciable useful life, leaving only $500.

Bill and his wife file a joint return and have taxable income of $365,000.

Bill’s Deductions

Calculation With Deduction Limits

Bill’s income from ABC was $100, so his maximum possible deduction is $20. The Deduction Limit is the greater of:

  • 3% of 50% of $0 = $0

OR

  • The sum of:
    • 3% of 25% of $0 = 0; plus
    • 3% of 2.5% of $20,000 = $15 = $15

Thus, ignoring his personal taxable income for the moment, Bill may deduct $15, not $20, against his $100 of income from ABC.

NOTE: If ABC ditches the management agreement and pays its own employees directly, it increases Bill’s deduction by 3% of 25% of $500, or $3.75.

Bill’s income from XYZ was $150, so his maximum possible deduction is $30. The Deduction Limit is the greater of:

  • 2% of 50% of $3,000 = $30

OR

  • The sum of:
    • 2% of 25% of $3,000 = 15; plus
    • 2% of 2.5% of $500 = $0.25 = $15.25

Thus, even ignoring his personal taxable income, Bill may deduct the whole $30 against his $150 of income from XYZ.

Calculation Based on Personal Taxable Income

Bill’s personal taxable income doesn’t affect the calculation for XYZ, because he was allowed the full 20% deduction even taking the Deduction Limits into account.

For ABC, Bill’s nominal 20% deduction was $20, but under the Deduction Limits it was reduced by $5, to $15.

If Bill and his wife had taxable income of $315,000 or less, they could ignore the Deduction Limits entirely and deduct the full $20. If they had taxable income of $415,000 or more, they would be limited to the $15. Because their taxable income is $365,000, halfway between $315,000 and $415,000, they are subject, in effect, to half the Deduction Limits, and can deduct $17.50 (and if their income were a quarter of the way they would be subject to a quarter of the Deduction Limits, etc.).

***

Because most real estate projects and startups generate losses in the early years, the effect of section 199A on the Crowdfunding and ICO markets might be muted. Nevertheless, I expect some changes:

  • Many real estate sponsors will at least explore doing away with management agreements in favor of employing staff on a project-by-project basis.
  • Every company anticipating taxable income should analyze whether investors will be entitled to a deduction.
  • Because lower-income investors aren’t subject to the Deduction Limits, maybe Title III offerings and Regulation A offerings to non-accredited investors become more attractive, relatively speaking.
  • I expect platforms and issuers to advertise “Eligible for 20% Deduction!” Maybe even with numbers.
  • The allocation of total cost between building and land, already important for depreciation, is now even more important, increasing employment for appraisers.
  • Now every business needs to keep track of wages and the cost of property, and report each investor’s share on Form K-1. So the cost of accounting will go up.

As for filing your tax return on a postcard? It better be a really big postcard.

New Tax Law Should Boost Crowdfunding

Whatever you think of the new tax law as public policy, adding to the country’s fiscal deficit and favoring the wealthy over the poor and the middle class, it includes several provisions that should make Crowdfunding investments more attractive, especially for real estate:

  • Income from “pass-thru” entities like limited liability companies and limited partnerships is eligible for a 20% deduction, off the top. This immediately makes investing in a pass-thru interest more attractive than investing in a publicly-traded stock, despite the one-time increase in value for publicly-traded corporations (all of them “C” corporations for tax purposes) due to the decrease in corporate tax rates.
  • Real property may now be depreciated faster, resulting in higher depreciation deductions – and thus lower taxable income – in the early years.
  • Depreciation of personal property (equipment, etc.) is also accelerated.

Lucky for me, the new law also presents many opportunities to change the structure of your business to save taxes, penalizing some activities, rewarding others. If you’d like to talk about maximizing the benefits for your business, let me know.

Cryptocurrencies: There’s Nothing New Under The Sun

Blockchain technology is revolutionary, promising to disrupt many of today’s industries. In contrast, the cryptocurrencies that live on the blockchain – to avoid confusion, I’m going to refer to cryptocurrencies as “tokens” – are really just high-tech manifestations of traditional ideas.

Broadly speaking, there are three kinds of tokens today:

  • Tokens like Bitcoin that are intended to function as currencies
  • Tokens that represent economic interests in businesses, e., securities
  • Tokens that give the holder some kind of contract right in the business conducted by the issuer, g., a distributed storage network

Tokens that are intended to function as currencies are like, well, they’re like currencies. They’re secure, they’re anonymous (maybe), they’re decentralized, but fundamentally they’re like paper money. The idea of paper money was revolutionary, rendering the barter economy obsolete. A digital representation of paper money is incrementally better, but not revolutionary.

Tokens that are securities – digital stock certificates – are helpful and better than paper or Excel spreadsheets but obviously not revolutionary.

The most interesting kind of tokens are the third:  tokens that give the holder the right to participate in a business.

Imagine you’re Henry Ford designing an automobile. You need a lot of capital. Your investment banker suggests you sell stock on Wall Street, but someone else suggests a different approach. You publish design specifications for your new automobile in something you happen to call a “Whitepaper,” and you sell to the public a limited number of licenses giving the holder the right to manufacture tires (or oil filters, or whatever) based on those specifications.

You just sold tokens, even though the blockchain doesn’t exist and you keep track of the sales in a red leather book.

Financially, you’ve pre-sold licensing rights. Some pros and cons versus selling stock:

  • On the plus side, you still own 100% of your company.
  • On the minus side, you have reduced or eliminated a future revenue stream for the company, e., licensing revenue.
  • On the plus side, because the tokens weren’t a security, you didn’t incur all that time and cost.
  • On the minus side, you really, really care about the quality of your cars – the whole future of your business depends on it – but the tokens might not end up in the hands of the highest-quality suppliers. That’s especially true in a market frenzy that reminds you of Tulip Mania in 1637, where many buyers are low-information speculators.
  • On the plus side, if raising money by pre-selling licensing rights happens to be a super-cool thing, the token sale might raise a lot more money than the licensing rights are actually worth.
  • On the minus side, you didn’t get to deal with securities lawyers.

What about the pros and cons to token buyers?

  • On the minus side, you have far less legal protection, as a buyer and owner of the token, than you would as the buyer and owner of securities in a public company.
  • On the plus side, your specialized expertise as a parts designer or manufacturer might give you a unique ability to increase the value of Ford, and therefore the value of your token.
  • On the minus side, while you know a lot about your own abilities, and might know a lot about Henry Ford and his team, you know nothing at all about the other token buyers. If they turn out to be lousy parts designers and manufacturers, you lose.
  • On the plus side, if you think Ford Motor Company is going to be hugely successful and tokens are the only thing they’re selling, you have no choice.
  • On the minus side, the token probably gives you the right to benefit from only one aspect of the company’s business, g., parts for the the Model T. If the company pivots or expands, you might find yourself left behind.
  • On the plus side, if you’re in a Tulip Mania market, maybe you’ll buy the token today and next week you can double your money selling it to someone else.
  • On the minus side, if we look hard at Ford’s Whitepaper we realize it’s very ambiguous. Do I or Ford really know what I’m getting? Or is this going to end up in litigation?

Who knows where the pros and cons come out. Someday economists will explain whether and in what circumstances a token is more economically efficient than a traditional security.

I feel quite sure that tokens that are currencies and tokens that are digital stock certificates are here to stay, because while not revolutionary, each represents an undeniable, if incremental, improvement over today’s technology. I’m not so sure about tokens that represent prepaid products or services. Until we hear from the economists, the jury is still out.

Questions? Let me know.

Options Or Profits Interests For Key Employees of LLCs?

Co-Authored By: Steve Poulathas & Mark Roderick

You own an LLC and want to compensate key contributors with some kind of equity. Do you give them an equity interest in the Company today or an option acquire an equity interest in the future?

Before we get to that question:

  • Make sure that equity is the right answer for this particular employee. It’s great for key contributors to have a stake in the company, but if this particular employee is your CMO, a cash commission on sales might make more sense because it provides a more targeted incentive.
  • Make sure you’re giving the employee equity in the right business unit. If you operate a Crowdfunding platform, for example, and want to incentivize an IT guy, maybe the IT should be held in a separate entity and licensed to the operating company.
  • To dispel some confusion, a limited liability company can issue options. In fact, here’s a Stock Incentive Plan drafted for a limited liability company. The only thing a limited liability company can’t do is offer “incentive stock options,” otherwise known as ISOs, which provide special tax benefits to employees but are also subject to lots of rules.

Okay, equity is the right answer for this particular employee and you’re giving her equity in the right company. Now, what kind of equity?

There are lots of flavors of equity. These are the three you’re most likely to consider:

  • Outright Grant of Equity: Your employee will become a full owner right away, sharing in the current value of the business, possibly subject to a vesting period.
  • Profits Interest: Your employee will become a full owner right away, but economically will share only in the future appreciation of the Company, not the current value.
  • Option: Your employee won’t become an owner right away, but will have the right to buy an interest in the future based on today’s value – again allowing her to share in future appreciation but not current value.

In making your choice, there are three primary factors:

  • Economics: How much value are you trying to transfer to your employee, and when?
  • Messiness of Ownership Interests: If your employee becomes an owner of the business, even an owner subject to vesting and/or an owner whose economic rights are limited to future appreciation, you have to treat her as an owner. You have to give her information, you have to return her email when she asks (as an owner) why your salary is so high and why your husband is on the payroll, you have to send her a K-1 every year, and so forth.
  • Taxes: For better or worse (mostly worse), tax considerations are the principal driver behind many executive compensation decisions, a great example of the tail wagging the dog. If you thought the JOBS Act was hard to follow, take a look at section 409A of the Internal Revenue Code!

So here’s where we come out.

An outright grant of equity might be a good choice for a real startup assembling a team to get off the ground, as long as there is little or no value. By definition the founder isn’t giving up much economically, and the outright grant achieves a great tax result for the employee, namely capital gain rates on exit. The main downside is that the employee is a real owner, entitled to information, etc. But that’s not the end of the world, especially if the employee is in the nature of a co-founder.

(If your company already has value, then you’re giving something away, by definition, and your employee has to pay tax.)

A profits interest is just like an outright grant except for the economics:  there is no immediate transfer of value. But the tax treatment is the same (no deduction for the company, capital gain at exit for the employee) and the employee is a full owner right away.

An option is economically very similar to a profits interest, because the employee shares only in future appreciation, not current value (for tax reasons, the option exercise price can’t be lower than the current value). But otherwise they’re the opposite. The employee isn’t treated as an owner until she exercises the option. And upon exercise, she recognizes ordinary income, not capital gain, while the company gets a deduction.

For a company with just a few key contributors a profits interest isn’t bad. You give your employees a great tax result and what the heck, what are a few more owners among close friends? But for a company with more than a few key contributors the option is better only because it’s so much easier to keep a tighter cap table. And while the tax treatment of the employee isn’t as favorable, I’ve never seen an employee refuse an option for that reason.

Non-Compete Covenants In Crowdfunding And Fintech

Co-Authored By: Adam Gersh & Mark Roderick

Taking a break from securities laws, we’ll take a look at using non-compete covenants in the Crowdfunding and Fintech world.

By “non-compete agreement,” we mean a contract that prohibits an employee from being employed by, or engaging in, a competitive business after she leaves.

EXAMPLE:  Real estate Crowdfunding company ABC requires its non-clerical employees to sign an agreement promising not to work for any other real estate Crowdfunding business for two years after termination of employment.

To be clear, when we say “non-compete agreement” in this post we don’t mean (1) a confidentiality agreement (a contract that prohibits the employee or contractor from using trade secrets or other confidential information), or (2) a non-solicitation agreement (a contract that prohibits the employee or contractor from soliciting customers or employees after she leaves). Confidentiality agreements and non-solicitation agreements are often used in conjunction with non-compete agreements but generally don’t raise the same legal and ethical questions.

Are Non-Compete Agreements Ethical?

Over the last year, I’ve seen a lot of press arguing that non-compete agreements are unethical — a form of human bondage. It’s more complicated, in my opinion.

When the U.S. economy was based on manufacturing, no one thought it was okay for an employee to haul away his employer’s tools when he quit. In today’s knowledge-based economy, where a $65 billion taxi company called Uber owns no taxis, the assets of most companies are intangible, i.e., knowledge and information. If employees can haul away those assets when they leave, there’s a problem.

Most of the time, employers are trying to protect two things:  confidential information and contacts/relationships. If confidentiality agreements and non-solicitation agreements were easy to prove and enforce, we probably wouldn’t need non-compete agreements. The problem is that they’re very difficult to enforce because violations are very difficult to prove – did the former employee solicit the customer, or did the customer solicit her? So, companies use non-compete agreements as a sort of “backstop.”

Here are a few hypotheticals that illustrate the ethical dilemma:

  • Real estate Crowdfunding company ABC hires Jean Smith, who knows nothing about real estate or Crowdfunding. After three years she leaves and starts her own real estate Crowdfunding company, competing with ABC for deals and investors based on the relationships and reputation she developed while on ABC’s payroll.
  • The same facts as above except Jean was fired for embezzlement.
  • The same facts as above except Jean was laid off because her job was replaced by an algorithm.
  • The same facts as above except Jean brought her own personal contacts to ABC as investors.

Are Restrictive Covenants Enforceable?

I can’t count the number of times I’ve been asked “Non-competes aren’t enforceable, right?”

In general, that’s wrong. Properly-drafted non-compete agreements are as enforceable as any other contract in most American jurisdictions. The giant exception to that rule is California, where non-competes for employees are per se unenforceable (with limited exceptions).

Almost everywhere else, a non-compete agreement is enforceable as long as the agreement is “reasonable” to enforce the legitimate interests of the employer. Whether a given non-compete agreement is “reasonable” depends on lots of factors, including the duties of the employee in question (e.g., business development vs. clerical duties), the duration of the restriction, and the geographical limitation. Despite their name, non-compete agreements can’t be used to prohibit competition per se. They can be used only to prohibit competition that is unfair based on the facts and circumstances.

The geographical limitation in particular creates hard questions in Crowdfunding and Fintech, where many businesses are either national or international in scope.

EXAMPLE:  A dental practice in Chicago attracts 80% of its patients from a seven mile radius. It would be unreasonable for the practice to prohibit its employees from working in Texas. But a real estate Crowdfunding business in Chicago, with projects from California to Texas to New York, is a different story. Can that business prohibit its employees from working anywhere?

Then there’s the question of what the company’s business really is. Is it a general dentistry practice or a specialist orthodontic practice? Does the company do all kinds of real estate Crowdfunding or only residential fix-and-flips? With about eight and a half million accredited investors in the U.S. alone, but only a small fraction having signed up at Crowdfunding sites, are Crowdfunding companies – real estate or otherwise – even competing with one another in the traditional sense?

Things are even more complicated in the blockchain world. Are all companies issuing tokens competitors? No. But two companies issuing tokens based on distributed digital storage are probably competitors, even if one is based on New York and the other in Silicon Valley.

Do Non-Compete Agreements Apply Only to Employees?

No, non-compete agreements can be used for contractors and vendors as well as for employees.

Do Non-Compete Agreements Inhibit Innovation and Economic Growth?

We’ll leave that to the economists.

Are Non-Compete Agreements Effective?

In general, yes, they are very effective. Meaning:  an employee who is subject to non-compete agreements generally doesn’t compete.

For one thing, the employee generally wants to comply with her contract, even if the contract seems a little overbearing and a lawyer says it might not be enforceable. So she chooses a new job that doesn’t violate the non-compete agreement, if she can.

But most important, a company that hires an employee subject to a non-compete agreement can also be liable. Once it learns about the non-compete, the new employer usually withdraws its offer, effectively “enforcing” the non-compete on behalf of the former employer and forcing the employee to look for a job elsewhere. Every now and then a new employer wants the employee so much that it takes the risk, but very seldom.

Recommendations

If you’re a company and aren’t located in California, you should have your employees sign non-compete agreements, period. Think about what you’re trying to protect and draft the agreements accordingly.

If you’re an employee think hard before you sign one. It’s probably enforceable, and it might affect your ability to find another job if you leave.

Form of Agreement

Here is a form of an Invention, Non-Disclosure, And Non-Competition Agreement. In addition to a non-compete agreement, this contract includes a confidentiality agreement, a non-solicitation agreement, and a provision that makes the company the owner of any inventions of the employee, useful in most tech companies.

CAUTIONS:

  • Don’t assume this agreement will be right for your company or that it will be enforced as written in your state.
  • This contract was written for a real estate Crowdfunding portal. It can be modified for other Crowdfunding or Fintech companies.

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