Gone are the days of bashing your boss in the breakroom. Now, colleagues gather online to anonymously air their grievances.  A group of disgruntled Demand Media, Inc. employees did just that with their website DemandStudiosSucks.com.  Then Demand Media struck back.

Late last month, attorneys for Demand Media, a content production company whose properties include eHow, LIVESTRONG.com, Cracked.com, typeF.com, Trails.com and GolfLink, sent a letter to DemandStudiosSucks.com asking it to remove content that had been copyrighted by Demand Media.

The media company accused the people behind this censorious website of creating and maintaining “a forum in which users can, and do, post and misuse Demand Media’s trademark, copyrighted material, including confidential and proprietary copy editing tests.”  The letter also referenced “an internal presentation regarding the company’s business plans”, published without permission on DemandStudiosSucks.com.

Immediately, of course, the letter was posted on DemandStudiosSucks.com.

The next day, a user named “Partick O’Doare,” who has posted the majority of the content on the site, published an open letter addressing the claims made by Demand Media’s attorneys.  Although the website removed the content addressed in the letter, O’Doare explained that the site’s creators had not acknowledged any infringement in removing the content.

Instead, those behind the website claimed that their use of the Demand Media content fell under fair use guidelines, specifically protections for commentary and criticism.  “Let’s be honest,” the open letter says, “if ever there was a case of unequivocal fair use, this would be it.”  A statement which should raise flags to anyone who previously felt similarly.

Fair use is a defense to a claim of copyright infringement, but not other claims.  A fair use argument cannot simply succeed on its merits where other legal rights are violated.  Context matters.  So, for example, as seen in some Facebook “suck site” cases, fair use will not protect against a claim of defamation.  Employees who publish company trade secrets and other proprietary information cannot rely on fair use to defend against claims of violations of corporate and employment law.

O’Daire’s letter proudly boasts that the voices behind DemandStudiosSucks.com were fully prepared to defend themselves, citing the fair use cases Lenz v. Universal Music Corp. and Online Policy Group v. Diebold, Inc.

What’s the solution? There’s always the most traditional and perhaps the most primitive solution: Lock up the idea. Meaning: Do everything you can to make sure that anything that anyone does for you as a developer, contractor, employee, business partner, vendor or whatever is owned by you or your new company.

And that can certainly involve “work for hire” and similar agreements, but it also involves noncompete agreements. Or in other words, “I own everything, but just to be clear, in case you think that I don’t own everything, don’t even think of going to one of my competitors or opening up your own shop across the street.”

How sweet.

Actually, putting aside the quaintness (and crassness?) of that approach, its bigger problem is a dependence on contracts rather than trust. No, that’s not quite right – contracts are fine, but they miss the point. Reliance on contracts ignores key realities of how innovation happens.

And in certain rather important technology locales in the United States (READ: California), it also ignores the law. In California, for example, courts have routinely refused to enforce noncompetition agreements.

To the first point: Innovation is collaborative. Look no further than the invention of the telephone, which as everyone knows was invented by Alexander Graham Bell. Or … was it? Well, Bell did file the first successful (and successfully defended) patent for the telephone. But as Malcolm Gladwell wrote several years ago in The New Yorker,

[Elisha] Gray was working on the telephone at the same time that Bell was. In fact, the two filed notice with the Patent Office in Washington, DC, on the same day – February 14, 1876. Bell went on to make telephones with the company that later became AT&T. Gray went on to make telephones in partnership with Western Union and Thomas Edison, and – until Gray’s team was forced to settle a lawsuit with Bell’s company – the general consensus was that Gray and Edison’s telephone was better than Bell’s telephone.

Gladwell’s story about Bell and Gray and the telephone is an anecdote to paint the scene for an “invention session” organized by Nathan Myhrvold, formerly research director at Microsoft. Myhrvold’s idea was the innovation could by organized and “fabricated” (in a not-quite fair characterization) through modeling on the lesson of the telephone invention controversy: Namely, innovation could be – is – collaborative.

Which brings us to present-day California: What really happens if a noncompete is unenforceable? This week’s Washington Post published a fascinating story on Silicon Valley’s “culture of cooperation”. (“In a cutthroat world, some Web giants thrive by cooperating”, Washington Post, Saturday February 19, 2011.)

Emblematic of the view is that of Google’s soon-to-be former CEO Eric Schmidt, quoted by the Post from a Google blog post saying “How do you be big without being evil? We don’t trap end users. So if you don’t like Google, if for whatever reason we do a bad job for you, we make it easy for you to move to our competitor.”

The Post goes on to profile some of the more obvious West Coast tech giants, including (in addition to Google) Microsoft, Twitter, Facebook and Apple. Apple is presented as the counter example to the culture of cooperation, of course, with CEO Steve Jobs recently quoted saying “Open systems don’t always win.”

And yet, that one quote is really the extent of the Post story’s Apple bashing, with an insightful discussion of what works for different companies and cultures.

The California story – and the history behind the story – began to accelerate in the 1990s when California courts refused to enforce noncompetition agreements, which particularly affected the dot-com companies of Silicon Valley seeking to lock up talent and ideas. Talent mixed and mingled, traveling wide and far, as did ideas and, ultimately, innovation. The Post cautions that Google’s self-promoted reputation for open-system may be significant and influential, but it is also limited to services whose viral promotion drives traffic for Google’s core search advertising business. And Google search does not participate in the same open-system practice.

On the other hand, Gladwell’s and Myhrvold’s point about the nature of technical innovation seems to buttress policy support for the courts’ disdain for noncompetes. The gray area involves what constitutes “general knowledge, skills, techniques and learning”, which this more expansive view of innovation suggests should never be bottled up. It is not always easy to distinguish general knowledge from company-specific ideas, facts and techniques.

Noncompetes (where enforceable) are often used to get around this problem by simply saying, “You can’t work for our competitors. Period.” Which left Hewlett-Packard having to challenge former CEO Mark Hurd’s move to Oracle based on claimed breaches of confidentiality commitments, rather than noncompete. Hard to do.

According to the AP, the student, Tony Brown, was also given the celebrity treatment by Apple and wooed for technology jobs by Google and other companies.

Ultimately, Missouri backed down, but not before overhauling the University’s technology transfer policies, at least as they relate to student development and ownership of intellectual property.  In this case, “Inventions” and copyrights that might be considered “work-for-hire”.

Here’s the interesting issue: Brown, now a graduate student at the University of Missouri’s School of Journalism, was not then and is not now an employee or contracted researcher tied to the University. He was not a grant-receiving researcher or graduate student, and he was not participating in a traditional science or other technology “lab” environment.

It’s not clear from the reports whether he was receiving student aid, although aid was not a part of the University’s argument for its rights. In any event, under the University’s “Collected Rules and Regulations” receipt of student aid does not by itself cause a recipient to be deemed an “employee” of the University for IP ownership purposes.

Rather, Missouri argued that as an enrolled student at the University, developing the technology in a University class and presumably using University resources to do so, the University had a valid ownership claim to the intellectual property.

The AP story notes that the class professor had no involvement in the development of the app. And there was sufficient ambiguity in the relationship between Brown and the classwork itself – as well as, evidently, ambiguity in the applicability of the school’s IP policy to student work – to throw doubt into the strength of Missouri’s position.

Not surprisingly, Missouri modified its IP policies. But perhaps surprisingly, the changes were somewhat liberalizing.

Two particular provisions clarify that the University will not claim rights to non-“employee” student work when …

The Invention … was developed by a student as part of a University class project using no greater University resources than those generally available to all other students within the class or than those available to the student as part of his/her enrollment with the University.

Or

The Invention … was developed by a student on his/her own free time, outside of any University class or sponsored activity, and using no greater University resources than those generally available to all other students as part of their enrollment with the University.

The key does seem to be the “using no greater University resources than those generally available to all other students” etc. language.

AP went on to cite Yale and Carnegie Mellon as leaders in the trend to create clarity so as, presumably, to make themselves more inventor- and entrepreneur-friendly. “Missouri and some other universities are hoping that giving students more rights, along with other incentives to invent, will make the institution more attractive to young entrepreneurs.”

Interestingly, Missouri’s School of Journalism issued an online press release last April touting another successful app developed by Tony Brown, this time a news aggregator app for Apple’s iPad.

The implication from the release is that Brown’s news app was developed much more collaboratively with the School’s faculty and resources, as well as other student inventors. The further implication, then, is that the University claimed rights in the news app, which may be significant in that, according to the release, a previous Brown news app was “became the fifth highest-rated news application on the iTunes store in the week following its launch”.

Not in dispute is that the employee’s actions violated the company’s social media and other personnel policies, which (among other things) prohibited depicting the company ‘in any way’ on Facebook or other social media sites or from “disparaging” or “discriminatory” “comments when discussing the company or the employee’s superiors” and “co-workers.”

In dispute is whether that social media policy – and the company’s actions in enforcing the policy – violated public policy, in particular Federal labor law.  This came into fast relief when the National Labor Relations Board (NLRB) subsequently filed a complaint against the company, charging the company with violations of the employee’s rights under the National Labor Relations Act (NLRA).

The company is American Medical Response (AMR), an ambulance service provider.  The incident followed a customer complaint about the employee’s work, when the employee’s supervisor asked the employee to prepare a report about the incident.  At that point, the employee sought but was denied representation from her union.

Later that day, the employee posted negative remarks about her supervisor and AMR on her personal Facebook page, through her home computer.  It appears that at no time did she use AMR’s technology or services to conduct her actions.

According to the New York Times story about the case, the employee’s grievance – and subsequent social media commentary – related primarily the fact that her supervisor barred a representative of the Teamsters to assist her in preparing her report.

The employee’s Facebook comments sparked an exchange of further commentary by other AMR employees, and further disparaging comments by the employee about the supervisor.  That prompted her suspension and later termination.

Two important things to note about this case:

1. “Concerted Activity” under NLRA.

As the NLRB stated in its press release about the case, “the employee’s Facebook postings constituted protected concerted activity” under the NLRA.  “Protected concerted activities” under the NLRA include the right of employees to “Discuss wages, working conditions or union organizing with co-workers or a union” and “Act with co-workers to improve working conditions by raising complaints with an employer or a government agency”.

Employers may not, among other things, “Fire, demote, transfer, reduce hours or take other adverse action against employees who join or support a union or act with co-workers for mutual aid and protection, or who refuse to engage in such activity.” (emphasis added)

According to the New York Times, this case is the first where the NLRB interpreted its powers to include regulation of employer conduct related to employee activities in social networking.

What is not clear is whether the NLRB would have filed this case – and whether this would have constituted “protected concerted activity” – had the employee’s conduct been limited to solo Facebook complaints, rather than engaging with co-workers and an online community.

2. Social Media Policies Violative of NLRA.

As described in the New York Times, AMR’s policies “barred employees from depicting the company ‘in any way’ on Facebook or other social media sites in which they post pictures of themselves.”  Another policy prohibited “disparaging” or “discriminatory” “comments when discussing the company or the employee’s superiors” and “co-workers.”

According to the NLRB, “Such provisions constitute interference with employees in the exercise of their right to engage in protected concerted activity.”

This view is troubling if only in the sense that these types of policies and provisions are common for companies adapting to social media.  As Bret Cohen of Hogan Lovells wrote recently about the case, “Though such policies are most likely to be invoked when employees post material to the Internet or social media sites that exhibit clear insubordination or disloyalty to the company, the NLRB was clear in expressing its concern for the possibility for companies to use the policies to stifle union-related employee communications.”

The case is set for hearing on January 25, 2011.

For a group that tends to dispute everything even a position that would presumably only side in their own interest, academics too must concede the legal ambiguity of the copyright law’s “work for hire” doctrine when applied to the academic setting.  What is probably not in dispute is, as one commentator describes it, that “Traditionally, it was presumed that educators owned copyrights to academic work they have authored or created.”

True, it was (and is still) assumed, but it was never codified in the Copyright Act and never directly established by caselaw.  That too is not in dispute.  Thus to characterize a theoretical university’s position, on the bare facts of the employment relationship: “Educational institutions … claim an interest in the work and point to the faculty’s use of their resources in its creation.  Institutions also can assert that producing such work is part of the educators’ employment obligation.” (http://ow.ly/18O9A)

To be sure, with exceptions for adjuncts and other guest lecturers, most teachers would be considered employees of their colleges and universities.  It is hard to imagine that most teachers would care to dispute that claim, as evidenced by their benefits eligibility, academic protections and broad use of school resources, among other obvious indicia.

The reality is – or, until recently, was – that none of this really mattered.  Not much was at stake in the pre-online and –distance education days.  In one of the rare but prominent pre-internet era cases addressing the issue at all, an “academic exception” to the copyright work for hire doctrine was acknowledged based both on tradition and policy.  The University of Chicago’s and Federal Judge Richard Posner wrote for the 7th Circuit in Hays v. Sony Corp. of America (847 F.2d 412, 416 (7th Cir. 1988)):

“Although college and university teachers do academic writing as part of their employment responsibilities and use their employer’s paper, copier, secretarial staff, and (often) computer facilities in that writing, the universal assumption and practice was that (in the absence of an explicit agreement as to who had the right to copyright) the right to copyright such writing belonged to the teacher rather than to the college or university.

“Nevertheless it is widely believed that the 1976 Act abolished the teacher exception [citations omitted] – though, if so, probably inadvertently . . . .  To a literalist of statutory interpretation, the conclusion that the Act abolished the exception may seem inescapable . . . .  But considering the havoc that such a conclusion would wreak in the settled practices of academic institutions, the lack of fit between the policy of the work-for-hire doctrine and the conditions of academic production, and the absence of any indication that Congress meant to abolish the teacher exception, we might, if forced to decide the issue, conclude that the exception has survived.”

In any event, a university’s hard-line position on this might only be ‘theoretical’ because, as noted by the Sloan Consortium, “[m]any institutions have created policies that formally recognize the academic exception and have voluntarily given faculty ownership of scholarly and teaching works.”

Any actual kerfuffle over this issue was one of recent making, illustrated by a dispute about ten years ago between Harvard Law School and Harvard law professor member Arthur Miller.  Without permission from Harvard, Miller had contracted with Concord University School of Law to videotape law lectures for use by Concord’s students.  This despite Harvard’s policy prohibiting faculty from outside teaching without permission.  (Miller evidently argued that, since the sessions were videotapes only and not live lectures, he was not technically “teaching” and not thereby violating the Harvard policy.)

As already noted, this issue hardly mattered until the relatively recent rise of the internet and the accompanying explosive commercial growth of online education.  In 2000, for example, the New York Times described this venture involving Williams College:

“Global Education Network, a company founded partly by Herb Allen, the president of the venture-capital firm Allen & Co., has approached Williams and Brown University, among others, with an invitation to contribute course material to a proposed for-profit Web site providing on line liberal arts education for adults.  Officials at Williams have said that the venture could earn the institution upwards of $250,000 per year, per course, for up to 10 courses.”

The looming academic food fight was noted only in parenthetical, discussing a different venture involving the University of Chicago where “Payment to participating professors has not yet been set.”

So, then, there is academic research and publishing tradition, there is copyright “work for hire” doctrine, there is caselaw including from one of the foremost conservative federal judges (and, not incidentally, academic heavy-weight).  There is analogy from patent law and university technology transfer practices, where inventions and discoveries are almost always owned by the institution for which a researcher works.  But there is no “academic exception” to “work for hire” doctrine, leaving faculty and non-faculty researchers and teachers potentially subject to the uncertainties of a fast-changing academic and commercial marketplace.  Academic copyright and research policies have attempted to allay faculty concerns, as have teacher participation in commercial ventures like those described above for Williams and Chicago.

I will write more on this subject shortly.

Draws versus Salaries

In an S-Corp, the shareholders are required to take salaries, not draws.  If an S corp shareholder takes out salary of $20,000, she will still pick up that $20,000 as W-2 income.  Taxes would have to be withheld, and shareholders would receive a W-2 at the end of the year.

In an LLC, members take “draws” rather than salaries, and taxes are not withheld on those draws.  A draw means an owner is just taking money out of the bank against the balance sheet account called partner draw (liability).  Instead, if an owner takes out $20,000 in an LLC, it doesn’t affect her ownership income, and she’ll receive a K-1 at the end of the year showing that $20,000 in income.

Unlike salaries in an S corp, LLC ownership draws do not reduce the company’s income.  A draw is not an expense, so although cash is decreased by the amount taken out as a draw, the payout of the draw does not constitute an expense that would lower net income of the company.  A salary is an expense account on the income statement that reduces your net income and your cash account.

Profits and Losses of the Company

In either case, shareholders or members will receive a K-1 from the company at the end of the year.  If the business has net income for the year (including deduction for salaries paid but excluding deduction for any draws) then that income will pass through to the owners on a K-1.

Therefore, while a company’s owners could reduce taxable income through salary payments in an S corp, they’re going to recognize the same total 1040 income through the combination of salaries and profit distributions via K-1.  Self-employment taxes (discussed below) will effectively cost them the same, and the only possible variable will be varying effects of marginal tax rates and capital gains treatment of profits versus salary.  (More on that last point under a separate posting coming soon.)

Self employment (SE) taxes

In an S-Corp, a shareholder is still (effectively) going to pay the full SE tax.  A shareholder cannot avoid SE taxes by taking salary rather than a draw, because while the company would indeed pay half of the SE tax, since the shareholder is essentially the company, the shareholder is effectively paying all of it.  And that would then be the same as if an LLC owner received all of here income on via owner draws.

It also has obvious risks, particularly to a seller.  Commonly, the earnout involves a seller who will continue to participate in the business after the sale under some sort of employment or consulting arrangement with the new owners.  This theoretically gives a seller an ability to have some control over the post-closing success of the business, while giving the purchaser a way to incentivize (and control) the seller’s employment or consulting performance.

Almost by definition and necessity, the seller will have less control over the success of the business post-closing, even a seller given real management control over the purchased business.  Management, staffing, budget, infrastructure, sales and marketing capabilities and other resources will in varying respects be subject to the input, discretion and control of the new owners.  Further, the very existence, corporate structure and ownership of the business are matters now beyond the control of the seller, who might see the new owners turn around and re-sell the business to an entirely new owner.  That new owner may or may not be bound by the earnout, although that concern can be addressed.  What cannot so easily be addressed is that the seller’s still-unpaid earnout is now subject to the ownership control of an entirely new set of players.

Put another way, whereas with a cash sale of a business there may be little interest or concern about who your purchaser is, an sale structured with earnout makes the sale of a business much more like a merger and partner-like investment in the business of the purchaser.  Understanding who you’re dealing with and your trust and expectations about their future would then be front and center concerns.

All of these factors need be considered when selling a business for a price that partly or largely consists of an earnout.  Or more broadly, all of these factors need be considered when selling a business and even considering a structure with an earnout.  Several immediate things come to mind:

1. Assuming the seller will be participating in the business post-closing, performance metrics for the earnout should be reasonably related to the job duties under the employment or consulting agreement.  While revenue growth of the business post-closing may be one obvious criteria for measuring success or failure, operational influence on that revenue growth will clearly affect its attainability.  A seller may sincerely believe that the business will continue to grow at a 20% annual clip, but the seller also probably assumes reasonable continuity in management in those forecasts.  On the other hand, from the perspective that this type of acquisition is more of a joint venture or other strategic partnership, rather than a simple exchange of asset for cash, the expected input by the purchaser of financial and other resources into the business certainly motivates the seller to sell.  A not unreasonable purchaser will seek to figure these inputs into the calculus for revenue growth, profitability, growth of customers and so forth.  This gets back to the question of why each party is doing the deal in the first place and the trust – and due diligence – in the other party’s promises about future performance.

2. Due diligence.  This may be challenging, because a seller may not easily have access to a purchaser’s financials books and records.  But due diligence relates not only to the management and financial stability of the purchaser, but also to the purchaser’s wherewithal to fund and operate the purchased business post-closing.  As noted above, both of these aspects of due diligence underlie a well-constructed earnout.  It is not so easy – and, really, can be quite difficult and costly – to “undo” an earnout that ends up being dishonored or, in fairness to both sides, disappointing to one side or the other.  Disappointment can arise from poorly conceived earnout metrics resulting in failure to achieve goals.  Causes for that failure may not be easily allocated between the parties, and in any event an earnout may not provide a mechanism for doing so.  With people you know, it can be difficult to say in advance that you will be able to trust your business partner in the event of a dispute.  Sometimes, acquisitions occur between parties that have worked together and known each other for long periods, making this aspect of an earnout less risky.  In the context when you have no actual history working with that business partner, however, earnouts place a premium on a seller’s ability to trust their new business partners to resolve potential business disputes amicably and fairly.

3. Accounting issues.  Bear in mind that accounting treatment may vary (and potentially wildly) between seller and purchaser concepts like revenue recognition; prepaid accounts such as subscriptions and prepaid rent; allocation of administrative and overhead charges and capitalization or amortization of asset costs.  So, a seller forecasting financial performance as a basis for evaluating and negotiating an earnout will want to take care in either (a) incorporating variances in accounting (for example: GAAP versus cash accounting) into his thinking or (b) negotiating careful terms about treatment of financial components such as those listed above.  Provision for apples-to-apples treatment comparing pre-sale to post-sale performance can be important.

4. Change of control.  A seller might consider seeking protection against a purchaser’s subsequent transfer of the business impacting an as-yet unfulfilled earnout.  A “change of control” clause in a sale agreements would trigger immediate payment or acceleration of unpaid (including not yet earned) earnout payments.  The real problem sellers try to address is the uncertainty thrown into the picture by the insertion of a new controlling ownership, which uncertainty itself creates difficulties in quantifying what should actually happen if a change of control occurs.  A purchaser might argue that nothing should happen, that all obligations remain in place and the company is still bound, etc. etc.  And there might be some merit to that argument, so that the flexibility of a seller to simply work under the new ownership might be desirable under certain circumstances.  The seller might respond that they signed up to do business only with one particular party, and they staked their financial future on that party.  That argument, too, might have merit, although the purchaser could still respond that re-transfers and changes of control are known risks in business and should have been calculated into the earnout payments in the first place.

Bottom line and lawyer’s perspective: The real crux with an earnout is the due diligence prong above, because ultimately, you don’t want to have a dispute.  If you sell yourself into a situation where you have to litigate in order to get your money, you’re not well off using an earnout.