The Internet is a game changer for entrepreneurs. Never before has a medium existed where new ventures can not only compete with large companies, but often outmaneuver those behemoths by thinking out of the box, being flexible, and acting quickly. While you are undoubtedly focused on growth when launching a new business, mitigating legal risk requires a bit of attention as well. With this in mind, let’s take a look at nine legal tips for protecting your online business.
1. LLC or S-Corp or C-Corp
If at all possible, every new business owner should form a business entity. Launching and running a business is much like living – you are going to make mistakes. Mistakes are normal. Remember, Apple once fired Steve Jobs. The purpose of a business entity is to create a shield between the debts and liabilities of the business and your personal assets in case your mistakes are egregious enough to be classified as “sh*t hitting the fan.”
So, what entity do you select? State law governs business entities, so you should always speak with local legal counsel AND a business accountant before making a choice. Politicians have great enthusiasm for coming up with taxes and fees applicable to business entities, so knowing the lay of the land in your state is critical. Having said this, following are my general thoughts on the best business entities for particular scenarios.
“Watch Out Zuckerberg”
You’ve come up with the ultimate idea. The business plan is to pick up venture capital funding, grow like mad, go public, and block out the sun over Mark Zuckerberg’s homes as your yacht docks in San Francisco Bay. Yes, I realize Zuckerberg lives in Palo Alto. It’s a big yacht.
On a serious note, a Delaware C-Corporation is the appropriate choice if the goal of the business is to attract venture capital funding and go public. Venture capitalists rarely invest in businesses not configured as Delaware C-Corporations because of Delaware’s favorable investor laws. Once formed, the company then needs to register as a foreign entity doing business in your state so long as you don’t reside in Delaware.
Again, if the goal is to go public, the Delaware C-Corporation is your only choice. If going public is not a concern, then you have two other options.
If the initial startup money you contribute to the business will result in a diet of various ramen meals for the foreseeable future, then I’m a fan of the limited liability company. Owners of LLCs can take monetary draws as needed instead of being forced to stick to a rigid salary structure. This flexibility is critical when revenues and cash flow are unstable, which is often the case during the first year or two of a new business. Once the financials stabilize, the members can convert the entity to an S-Corporation for tax purposes. Doing so will save the members on employment tax as a certain percentage of the money taken out of the company can be received as dividends upon which there is no employment tax.
“Eating Ramen With Meat”
If the company will have sufficient funds to operate for a year at launch without you pulling money out, then forming an S-Corporation is often optimal. Unlike an LLC, a corporation is not the most flexible of beasts. However, the entity requires shareholders to pay less in taxes when the working shareholders take a “reasonable salary” with the rest of the money pulled out of the entity in dividends. The savings become significant as you grow.
2. Check the Box
If a visitor to your online property takes any action – purchase, open an account, etc. – require them to check the box and keep a log of the action. A judge will view the click as acceptance of the language of the terms and hold the visitor to those terms which are written in your favor.
Ah, but what if you have an online property that doesn’t require visitors to take an action where you can use a check the box process? For example, a blog. In theory, you can create a pop-up that prevents the visitor from accessing the site unless they “check the box” agreeing to the legal documents. As you’ve probably noticed, almost no sites take this step. The reason is most visitors will simply hit the back button and abandon the property to return to the search engines or wherever they came from. Fortunately, most online properties facing this problem also face nominal legal threats since the sites tend to be informational in nature. Given this, most owners of properties of this type will publish a simple set of terms with the understanding visitors will not be bound by the language.
3. DMCA Compliance
Interactivity is the modern trend on the web. From web design to social media campaigns, companies small and large seek to encourage visitors to post content, messages, and anything else one can think of. If you allow visitors to post ANYTHING on your website or app, then DMCA compliance is a must.
The Digital Millennium Copyright Act [“DMCA”] was enacted into law in 1998 to govern copyright infringement disputes on what was then an infantile commercial Internet. As a very general rule, the DMCA provides online service providers [websites, apps, etc.] with “safe harbor immunity” from copyright infringement claims arising from content posted by users. Consider YouTube. If I copy a band’s album and publish it on YouTube, I’m committing copyright infringement. Under the DMCA, the owner of the copyright can sue me, but cannot sue YouTube. If you allow visitors to post content to your online properties, known as “user-generated content,” then you should seek out the safety of the DMCA.
As with most things in life, the immunity comes at a cost – your soul! No, no. No soul, but you must follow a compliance process. You can read more here.
4. Class Action Waiver
Terms and conditions are written to protect an online business from liability. A class action waiver should be included in your terms. A class action waiver prevents users from teaming up in one massive lawsuit against your business. Instead, each visitor is required to pursue their claim separately, which often kills the motivation for bringing a lawsuit in the first place. Let’s consider an example.
Bob sells an herbal Magic “Hey Now” Marriage Romance Pill online. The pill is comprised of a combination of ground rose petals, vitamin C [always need vitamin C], ground unicorn horn, and the dust from a time travel machine. Bob promises that if each spouse takes one pill at the same time, they will experience a romantic burst similar to the first time they met. All for three low, low payments of $49.99.
As you might expect, the Magic “Hey Now” Marriage Romance Pill is a winner. Sales are through the roof. Then the complaints start. For 20 percent of couples, Hey Now turns into “Hey Wow” as the customers visualize angry unicorns chasing them through a field. An investigation reveals the Chinese supplier of the 100 percent pure ground unicorn horn for Bob’s product has actually only been using 25 percent ground unicorn with the difference comprised of ground up disregarded Blackberry phones, the tears of the head designer of Windows 8, and the shredded test results of Theranos products – the misery trifecta.
Bob has a legal problem. If he’s incorporated a class action waiver in his terms as well as a “check the box” approach when customers made purchases, his problem isn’t all that bad. Unhappy couples will be required to sue as individuals. The damages will equate to the amount paid for the product as well as any pain and suffering associated with being chased by angry unicorns. Expensive, but not a business killer assuming Bob has insurance in place.
Ah, but what if there is no class action waiver in Bob’s terms? Now the unhappy customers can band together and file suit. A better quality of lawyer will handle the case given the potential for millions in damages. Many of Bob’s customers who did not originally have problems with the “Hey Now” Pill will no doubt suddenly claim they are suddenly being haunted by evil unicorns given the potential for a settlement payout. In short, a more complicated and expensive case with Bob’s business potentially going belly up.
Class action waiver clauses should always be included in the terms and conditions of a website or app. Doing so can often prevent small legal problems from becoming massive legal disasters.
5. Mandatory Arbitration Clauses
Much like a class action waiver, your terms and conditions should always include mandatory arbitration clauses. Juries can become emotionally inflamed, and award damages accordingly. Most people have heard of the three million dollar judgment a jury returned against McDonald’s for serving hot coffee that was too hot. In truth, the coffee was too hot, but the damages awarded by the jury were a tad high. The injured plaintiff had offered to settle the case for $20,000 with McDonald’s countering with $800. The jury awarded $200,000 in actual damages and $2,700,000 in punitive damages. The plaintiff was certainly “Lovin’ it.”
There are no juries in arbitration hearings. Cases are heard and decided by an arbitrator who is typically a retired judge or an attorney. As a general rule, arbitrators tend to be more business-friendly than juries. If the “hot coffee” case had been arbitrated, McDonald’s likely would have paid no more than $20,000 plus medical costs – a wee bit less than the amount awarded by the jury.
By including an arbitration clause in the terms of a website or app, one can put the case in front of a decision maker who is more likely to decide in your favor. Make sure your terms contain such a clause.
6. Choice of Forum Clauses
Your business is in Los Angeles, California. A customer files a lawsuit against you in New York. Where is the trial held? As an online business, most judges are going to force you to appear in the customer’s location, which is an expensive and time-consuming process even if you ultimately prevail. A choice of forum clause can help mitigate this risk.
As the name suggests, a choice of forum clause dictates where legal disputes are litigated. For example, Twitter’s choice of forum clause reads:
“All claims, legal proceedings or litigation arising in connection with the Services will be brought solely in the federal or state courts located in San Francisco County, California, United States, and you consent to the jurisdiction of and venue in such courts and waive any objection as to inconvenient forum.”
As long as you use the “check the box” approach mentioned previously, there is a better than 75 percent chance a court will enforce the choice of forum language in your terms and conditions. Why not 100 percent of the time? Different states consider different factors in determining whether to enforce choice of forum clauses with fairness being the ultimate test. A doctor in New York is likely going to be bound to such language. A retired, disabled 79-year-old woman in Maine is likely not.
7. Automatic Billing Disclaimers
Recurring billing represents a tremendous revenue-generating strategy. Customers pay you month after month after month until you build up a block of business that you can use to continue to grow the business/engage in a trophy wife or husband/retain an actual vampire to make this year’s Halloween party a real kicker.
The only problem with the recurring billing strategy is the temptation. Temptation? For some reasons, business owners are tempted to make it incredibly difficult for paying customers to become former customers by making it nigh impossible to find the cancellation page, if there even is one.
Legal authorities have noticed.
Elected representatives have noticed.
These two parties have worked together to pass laws in multiple states requiring online businesses to provide automatic billing disclosures to customers. These disclosures must provide clear, simple instructions for terminating the automated payments. Fail to comply with these requirements, and you risk both a class action lawsuit and being forced to refund every penny the customers in question have paid you.
Even the bent ones.
Here’s an overview of California’s Automatic Renewal Law.
If you are using a recurring billing model, understand and comply with the relevant state laws.
8. Sell, Share, or Rent User Information
“We will not sell, share, or rent your personal information to others.”
The vast majority of online businesses make this promise to their visitors. How noble…and disastrous.
Consider a simple question. If you make the above promise to visitors, how will you ever sell your business to a third party? The most valuable assets of online businesses are customer databases and mailing lists. In promising visitors their information will not be sold, rented or shared, you’ve eliminated the ability to sell the most valuable assets of your business. Don’t think so? Learn how a $700,000 dating site purchase failed for this very reason.
9. Collecting Personal Information From Children – Big Changes
If you gather information from kids under 13 online in the United States, you must comply with the Children’s Online Privacy Protection Act. Fail to do so, and you can face massive fines as Mattel and Hasbro just learned. Most businesses do not target young children of this sort since generating revenues can be difficult. However, change is coming that is going to rock much of the Internet, and I’ll let you in on the ugly secret since you’ve read this far.
In the first quarter of 2018, Europe will require online businesses to obtain parental verification before collecting information from children under 16. The new rule is found in Article 8 of the recently enacted General Data Protection Regulation. Fortunately, Member States of the EU can elect to lower the age to the COPPA-standard of “under 13” or somewhere between under 13 and 16. Unfortunately, there are 28 Member States at the moment, which means at least a few laggards will not do so. With penalties for failing to comply as high as four percent of global revenues or 20 million Euros, the new standard is going to cause a host of headaches for companies. Prepare yourself accordingly.
Working Committees are expected to clarify the new regulation in early 2017, so feel free to connect with me on LinkedIn or sign up to receive our newsletter in the right column. Over there. I promise each legal newsletter will be the most exciting thing you read each and every month.*
Protect Your Business
As promised, nine tips you can follow to reduce the legal risk of operating online significantly. Will these tips prevent all lawsuits? No. Any idiot can file a lawsuit if they have a couple of hundred bucks, but applying these tips will go a long way towards mitigating serious risks. Feel free to contact me with any questions.
Richard A. Chapo, Esq.
* If you don’t read anything else that month.