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Incubator, accelerator, cyberlab, venture catalyst these are some of the names used by companies that make a business out of nurturing Internet start-up companies from infancy to maturity. [FOOTNOTE 1]Incubators look for promising start-ups in their very early stages, sometimes before any significant capital is raised. [FOOTNOTE 2] For these fledgling companies, incubators can serve any number of functions: product counselor, financier, strategy consultant, accountant, lawyer, human resources department, Web designer, landlord, board member, licensor, seasoned business advisor (a role occasionally reserved for incubator staff over the age of 30) and others. Incubators also offer the possibility of leveraging their industry contacts to advance their incubatees’ interests. In exchange for filling these roles, incubators are generally provided with equity in their incubatees, with the hope that the value of these nascent companies will appreciate significantly over time. Despite a spate of recent press pieces decrying their value and utility, [FOOTNOTE 3]new incubator companies continue to surface and traditional businesses, including real estate developers, advertising and Web design agencies, accounting and consulting firms and media conglomerates, continue to develop and expand their incubator arms. [FOOTNOTE 4] For as many hats as the incubator wears, there are just as many legal issues that can arise. This article highlights a few of the legal issues facing incubators, and some of the liabilities to which they may be exposed, with the view towards suggesting possible protective measures. PROVIDING OFFICE SPACE The lessons of businesses like Yahoo! and Amazon.com demonstrate that the “first mover” usually wins the prize. At the root of the benefits incubators offer is the prospect of minimizing the time between a business’s conception and its introduction in the marketplace. One of the many ways in which an incubator shortcuts the business development process is by providing office space and equipment to its incubatees. This saves the incubatee from having to take time to find its initial space. In addition, an incubator often can accommodate increased space needs incrementally, saving the incubatee from incurring unnecessary additional expense of contracting for more space than it initially requires or the additional time of searching for new space to accommodate expansion. An added attraction is that, unlike traditional landlords, incubators rarely require personal guarantees of incubatees’ principals. Generally, the incubator makes space available to its incubatees by leasing it from a third party. The incubator then grants rights to its incubatees to use the space. As a preliminary matter, in order to facilitate the accommodation of its incubatees, the incubator should negotiate provisions in its lease to the effect that its incubatees are not considered sublessees. The landlord may, however, impose limits on the number of incubatees or employees on the premises, the number of square feet that incubatees may occupy, and the incubatees’ activities (e.g., power use, no hazmats, etc.). As a tenant, an incubator will, in most cases, be liable to the landlord for damage to the landlord’s premises caused by its incubatees. In addition, actions of incubatees may impose liability on the incubator for injury to employees or invitees of the incubatee (or others), damage to other tenants in the building (e.g., power overloads), damage to other incubatees or criminal activity. Furthermore, the incubator may be liable to the incubatee, as an invitee or subtenant, for hazardous conditions on the premises controlled by the incubator causing injury. An incubator should take several steps to help insulate itself from liability relating to the furnishing of office space. As a first measure, it should require that its incubatees waive any claims against the incubator for damages caused by other incubatees in the same building. In addition, the incubator can insist on obtaining indemnification from its incubatees. This form of protection may be illusory, however, since many incubatees will not have the resources to satisfy any indemnification claim. In addition, an incubator can insist that the incubatee maintain insurance to cover these contingencies (the incubator’s landlord will likely insist that the incubator also maintain insurance). However, insurance is likely to be unavailable for most criminal acts. As a result, the best means of avoiding criminal liability may be to employ programs to supervise activities of incubatee staff on the premises. The extent of the liability that an incubator may face as a result of providing space to an incubatee will depend on the instrument used to supply the space. For example, the parties may enter into a formal sublease of the space. As a sublessee, however, an incubatee generally has all of the salient statutory and common law rights of a tenant, which may impose unforeseen obligations on the incubator and impede the incubator’s ability to remove the incubatee from the space. Another arrangement is a license of the space. This license looks similar to a lease, but specifically disclaims any landlord-tenant relationship between the parties, provides for broader termination rights by the parties and may enable the incubator to avoid some of the problems associated with being a landlord. However, incubators should note that in the event the incubatee files for bankruptcy, the incubator’s rights under the U.S. Bankruptcy Code may differ based on whether the incubator and the incubatee have entered into a license or a lease. The Bankruptcy Code is quite specific about the use of space under lease by a company in bankruptcy, requiring that the bankrupt lessee continue to pay rent on a timely basis in order to maintain its rights under the lease. [FOOTNOTE 5]On the other hand, the Bankruptcy Court may treat a license as an executory contract, for which there are fewer specific rights and remedies against the non-debtor under the Bankruptcy Code. STOCK FOR SERVICES Notwithstanding the recent market turmoil relating to Internet and technology stocks, incubators are in the business to get equity. The value of an incubator appreciates as a result of appreciating valuations of its incubatees. However, many states (including California) clearly prohibit the granting of equity in exchange for services to be delivered in the future. [FOOTNOTE 6]In many jurisdictions, if proper consideration is not provided for the stock, it will not be considered fully paid and non-assessable. As a result, should the issuer become insolvent, the holder of such stock would be liable to creditors for an “assessment” equal to the value of the unpaid portion of the stock. [FOOTNOTE 7] While it is less than crystal clear, Delaware corporation law may provide a suitable solution for Delaware corporations to permit issuance of stock in exchange for services not yet rendered. Under �152 of the Delaware General Corporate Law (DGCL), a corporation’s stock will be deemed to be fully paid and nonassessable if either (a) all of the consideration for such stock is actually received by the corporation in the form of cash, services rendered, personal or real property, leases for real property or a combination thereof, or (b) the amount of the consideration determined to be capital (usually the par value of the stock) is received by the corporation in any of such forms and the corporation “has received a binding obligation of the subscriber or purchaser to pay the balance of the subscription or purchase price �” The statute does not specify, however, that the manner of payment of such balance must be with cash. Accordingly, it can be reasoned that the balance can be paid with a binding obligation to provide any of the forms of consideration enumerated in clause (a) of �152, including services. It is unfortunate that the only example of such a “binding obligation” in the commentary to �152 is a promissory note. However, the commentary does not state that a promissory note is the only possible example of such a binding agreement. Furthermore, this interpretation would not seem to be in conflict with the Delaware constitutional provision regarding consideration for stock, since, as the Comment to �152 prepared by the General Corporation Law Committee of the Delaware State Bar Association notes, the principal concern of that provision was to provide that an amount equal to the capital (which can be as little as par value) be of “constitutional quality” for protection of creditors. Any amount over the capital is considered surplus, and is not required to be of constitutional quality. [FOOTNOTE 8] If the above interpretation of �152 is correct, Delaware corporations are permitted to issue shares of stock against payment of the par value in cash or property and delivery of a binding agreement to deliver services in the future. Stock issued in this manner would be fully paid and non-assessable. More guidance from the Delaware courts on the meaning of �152 is needed, however, to obtain certainty regarding this approach. It should be noted, however, that there is case support for the proposition that the issuance of a license, as a contribution of property, is valid consideration for the issuance of corporate stock. [FOOTNOTE 9]Accordingly, incubators that provide Web design or other types of intellectual property-oriented services may wish to consider drafting their equity documentation as an exchange of equity for a grant of a license in such intellectual property. Incubators and incubatees must be aware of one additional potentially significant pitfall relating to stock for services arrangements. Under the accounting rules promulgated by the Financial Accounting Standards Board (FASB), a corporation is required to account for stock for services transactions based on the “fair value” of the transaction. [FOOTNOTE 10]Ordinarily, therefore, if an incubatee expects to receive services the parties have mutually valued at $1 million, it issues a number of shares, based on a mutual valuation of those shares at the time of the closing of the transaction, valued at $1 million, and records a corresponding expense on its books of $1million. FASB states, however, that, where the nature of the services are such that their value cannot be reliably determined, the stock for services transaction is more appropriately valued according to the price of the stock on the date on which services are provided, instead of on the transaction’s original closing date. [FOOTNOTE 11] Often the incubator agrees to provide services over a number of years. Accordingly, in an environment where the valuations of Internet companies rise geometrically over a short period of time, services which the incubatee valued at $1 million may actually cost the incubatee stock valued in accordance with FASB at $5 million or $10 million or more, depending on how much the value of the incubatee increases over the period of time in which the services are delivered. For the $1 million worth of services it receives the incubatee could be required to record an expense on its books of an amount much greater than $1 million. This would be a problematic outcome to say the least, as start-ups are held increasingly accountable to show profits in a reasonable time frame. FASB provides an exception to this general rule where the parties provide for a “commitment for performance” of the services to be rendered in exchange for the stock. FASB takes the position, however, that such a commitment requires more than a contractual agreement to provide the services, even if such an agreement provides for forfeiture of the stock in the event of a breach. Accounting firms have taken the position that such a commitment requires a contract that contains explicit language imposing a large cash payment or other specific disincentive for non-performance. The payment should be large enough so the incubator would perform even if it received a better offer from a third party. If this commitment is met, the parties will be able to value the transaction according to the price of the stock on the transaction’s closing date. [FOOTNOTE 12] CONFIDENTIALITY CONCERNS Confidentiality is another concern for everyone sharing the incubator’s premises, and there are possible breaches from any number of sources. Leaks can occur in any number of places, such as documents left in a shared conference room, idle chatter in elevators, business plan drafts visible in a trash can, etc. This can lead to potential claims that incubators have contributed to the unwanted dissemination of confidential information. To avoid potential claims relating to this issue, incubators should require that each of its incubatees execute a confidentiality agreement which waives any liability of the incubator for disclosure of confidential information resulting from any cause other than direct dissemination by the incubator, including any intentional action of another incubatee to obtain such confidential information or from any lax behavior of the incubator, such as leaving materials in shared conference rooms or upon desks or similar actions. Since incubators often get involved in businesses that overlap with the businesses of their incubatees, this agreement should also provide for a “residuals” clause that would permit the incubator to make general use of information retained in non-tangible form. [FOOTNOTE 13] CORPORATE OPPORTUNITY Incubators should also consider several issues relating to its officers serving as officers and directors of incubatees. A corporation’s officers and directors owe a fiduciary duty of loyalty to the corporation and its stockholders. One way this duty manifests itself is in the “corporate opportunity” doctrine, which prohibits officers, directors or controlling stockholders of a corporation from taking for their own or a third party’s benefit a business opportunity without first offering it to the corporation if (i) the opportunity is in the line of the corporation’s business, (ii) the corporation is financially able to exploit the opportunity, (iii) the corporation has an interest or expectancy in the opportunity, and (iv) taking the opportunity is in conflict with the officer’s, director’s or controlling stockholder’s duty to the corporation. An incubator may be exposed to liability under this doctrine if its staff serves as officers or directors of multiple incubatees with expectancies in relation to similar opportunities. There are a number of ways for the incubator to protect itself against these claims. First, the Delaware courts have held that a director may take or redirect an opportunity if (i) the opportunity was not presented to the director in his corporate capacity, (ii) the opportunity is not essential to the corporation, (iii) the corporation holds no interest or expectancy in the opportunity, and (iv) the director has not wrongfully employed the resources of the corporation in exploiting the opportunity. Another step that the incubator can take, pursuant to the recently revised �122 of the DGCL, is to require that the incubatee draft or revise its certificate of incorporation or pass a resolution of its board of directors renouncing in advance the corporation’s interest or expectancy in specified business opportunities or specified classes or categories of business opportunities, e.g. types or lines of business, transactions with certain business partners, opportunities in certain geographic regions, etc. Such provisions could also narrowly construe when a director or officer is operating in his or her corporate capacity. In addition, the incubatee’s certificate of incorporation could disclaim its directors’ fiduciary duties, and provide indemnification, to the maximum extent permitted by law. [FOOTNOTE 14] Clearly, the operation of any incubator involves many aspects of law, and exposure to many forms of liability. The incubator must be careful to strike a balance between implementing appropriate protections and fostering the nurturing atmosphere needed for the fledgling companies that it houses to grow and flourish. Marc S. Reisler is a partner, and Michael S. Poster an associate, in the media and Internet practice group of Rosenman & Colin LLP in New York City. Donald Siskind, counsel with the firm, David Mark,special counsel, and Jennifer Chin, associate, assisted in preparing this article. ::::FOOTNOTES:::: FN1Notwithstanding the various names used by these companies, they are referred to in this article as “incubators”. FN2Rather than seeking out companies originated by third parties, a number of incubators originate business concepts within their ranks and develop those concepts through separate corporate entities. Many of the issues discussed in this article do not apply to these “home grown” businesses. FN3 See, e.g.,“The Truth About Incubators,” Silicon Alley Reporter, Issue 38 and “Market Gives Cold Shoulder to Internet Incubators,” USA Today, Oct. 30, 2000. FN4Recently launched incubators of high-profile sponsors include 550 Digital Media Ventures Inc. ( Sony), Kickstart (Newmark Realty) and EMerge (S.L. Green Realty) FN511 U.S.C. �365(d)(2000) FN6California Gen. Corp. Law �409(a)(i) FN7 See, e.g., Del. Gen. Corp. Law � 162(a) ( Aspen Law & Business, 2000) (hereinafter DGCL). FN8Id. �152, CMT. FN9 West v. Sirian Lamp Company, 28 Del. Ch. 90, 37 A.2d 835 (1944); 37 A.L.R. 2d 913. FN10FASB Statement of Financial Accounting Standards No. 123, October 1995. FN11FASB Emerging Issues Task Force, Issue 96 18. FN12 See, Arthur Andersen, Accounting for Compensation Arrangements, 3rd Ed. (2000) FN13A typical residuals clause reads as follows: “The terms of confidentiality under this Agreement shall not be construed to limit either party’s right to independently develop or acquire products without use of the other party’s information. Further, either party shall be free to use for any purpose the residuals resulting from access to or work with such information, provided that such party shall maintain the confidentiality of such information as provided herein. The term “residuals” means information in non-tangible form, including ideas, concepts, know-how or techniques which may be retained in the minds of persons who have had access to the information, and who have made no effort to refresh their recollection in anticipation of or in conjunction with the use of said residuals. Further, neither party shall intentionally memorize the information so as to reduce it to a non-tangible form for the purpose of creating a residual. Neither party shall have any obligations to limit or restrict the assignment of such persons or to pay royalties for any work resulting from the use of residuals. However, the foregoing shall not be deemed to grant either party a license under the other party’s copyrights or patents. FN14 See US West v. Time Warner Inc., 1996 Del. Ch. LEXIS 55 for a general discussion of the issues discussed in this paragraph.

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