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Startup Mechanics

Startup Mechanics

This is the not-so-glamorous part of being a startup founder. Details on incorporating, vesting, dilution and cap tables don't typically spark your interest when reading about the next unicorn. If you don't cover the basics though, you may run into some problems that will end up costing you a lot of time, effort and money.

Formation. Why is it important? It creates a separate legal entity in order for the entity to pay its own taxes, be responsible for its own assets, liabilities, sign its own contracts, sue and be sued.

Incorporation. While there are different formation structures, for a startup expecting to grow exponentially, raise money and eventually exit, a C corp is the way to go. Investors can only invest in C corps. You may hear some advice from people, not necessarily in the startup world, to start with an LLC or something similar. This may work in the short term, but as you become more successful and need to raise money, you will have to convert to a C corp.

When to Incorporate?

Too soon: You are still in the idea stage, thinking of this as a side project, not sure if you're going to be doing this for a long time, or don't know if you're going to be working with other co-founders. Right time: You’ve started developing significant IP and want to make sure it's clearly owned, particularly if there's more than one of you creating it. You are ready to protect yourself as an individual and want all of the liabilities to be on the company rather than yourself. You are ready to start charging and need a separate bank account to collect the money.

Where to Incorporate? Most startups and a lot of companies incorporate in Delaware. The majority of lawyers working on corporate law in the U.S. know Delaware law. Most Venture Capital investors expect to see Delaware companies because it allows the most flexibility in terms of issuing shares and various other things. Delaware also has the best privacy protections for you as an owner. Once the entity is formed, you'll need to adopt bylaws to state how the company is going to be governed. You'll need to create a board, appoint directors, officers and assign IP to the company. You'll also need to give shares and assign ownership in the company. There are a couple of different options to help you with all of these. The first one is to hire a lawyer, particularly if you want something non-standard, need the one-on-one support or have already incorporated and want to switch. It usually costs somewhere between $2-5K + filing fees to incorporate a company with a lawyer. Some lawyers, particularly those who understand the startup lifecycle, may be willing to work with you to defer fees until you raise money. Another option for young startups is Clerky, especially if you're just going with the basics. It costs a few hundred dollars + filing fees. Make sure you don't commit one of the top 7 legal flops typically made when starting a business.

Assigning equity. Assigning equity is part of the incorporation process, especially when you have co-founders. You want to have this discussion early on and decide how equity will be distributed. It is critical you get this right and all founders feel it's fair. You are going to be working with your cofounders for a long time. If you are not fair in your split, resentment can build up. This is often the number one reason co-founders break up. Forward vs. Backwards thinking. When assigning equity to Co-Founders remember that all the effort is in front of you, not behind you. Even if you thought of the idea, built the prototype, closed the first sale or started months before your co-founder, your challenge lies in front of you. You're going to pivot and your prototype is probably going to bear no resemblance to the final product before it becomes successful.

Put it on paper. Document all transactions. Figure out a stock purchase agreement to record the ownership and use a “basic” cap table. Over time, as you issue shares to employees and investors, the cap table will become more complex. Start out with a very simple table and start recording how many shares each individual owns.

Vesting. Vesting is earning the right to permanent ownership of shares over time. The standard for vesting is 4 years with a 1 year cliff. This provides protection to the remaining founders. Let's assume you don’t have vesting and one of your co-founders decides to leave early on. Should the company get acquired later, the ex co-founder still gets the same amount of money as you. Vesting means founders and employees have skin in the game. Make sure you build restrictions on the allocation of shares. Should a founder leave, the company should have the right to take some of those shares back over time. As time progresses, the number of shares the company has the right to repurchase reduces. Filing an 83(b) election. There is one very important piece of paper that's part of the incorporation process called an 83B election. If you don't sign this form, you'll be taxed on the increase in value of your shares every time your shares vest. This can create huge personal and company tax liabilities. It's the one thing in incorporation that cannot be fixed. You have to file it with the IRS within 30 days and it's best to retain proof of mailing. If you get down the line in an acquisition or when you're doing a funding round, it will get asked for.

Fundraising. There is so much to this topic we couldn't possibly cover it all here. For more on fundraising check out our The Fun in Fundraising and Managing Fundraising Expectations posts. In very simple terms, you can either raise money on a priced round or a non-priced round, commonly known as convertible rounds. In a priced round, the shares are sold for a specific price at the time of that round. In an unpriced, or convertible round, the investor gives money now but the shares are given in the future. The reasoning behind this being the idea that startups will first raise money on an unpriced round and later they'll raise money on a priced round.

Priced round. The valuation of the round sets the price the investor will pay to buy a share. If company is doing a priced round, you'll want to hire a lawyer to help you. They'll be able to talk you through the entire process. Unpriced rounds. Companies and investors in more established tech hubs are used to an instrument called a SAFE, Simple Agreement For Future Equity. It's only a few pages long and easy to understand. On a SAFE or unpriced round, the investor is giving the company money now in return for the right to receive shares in a future round. When they invest in the early stages, investors are taking a much bigger risk and therefore want some kind of bonus or deal to reflect that. This is built into a SAFE through a valuation cap. This entitles investors to equity priced at the lower of the valuation cap or the pre-money valuation in subsequent financing. The benefits of a SAFE over a priced round is the simplicity. Know that while unpriced rounds and SAFEs are common in established tech hubs, they are not common in Oklahoma.

Dilution. Think of your company as a pie, where the size of the pie is the value of the company. In the early days, you have a massive slice of a very small pie. As your company grows, the size of the pie grows, but your slice becomes smaller because you're giving away or selling slices. In a high-growth startup, dilution is inevitable. The thing to remember is that you're still creating wealth for yourself and for investors. Be careful not to sell too much of the company early on. In the early days of the company, you're still trying to figure out what product you end up building, how it fits in the market, what you need to spend the money on, etc. Why raise more money than you need, if you can wait and raise it to higher valuation.

Hiring. Once you raise money, you are more than likely going to spend most of it on hiring. Governed by lots of laws and regulations, hiring is a complex area. Most of the rules you’ll have to abide by will depend largely on how you recruit talent and whether they are a contractor or employee. Contractors set their own work hours, work on a specific project and have an end goal that's clearly defined. They use their own equipment and are not vested or involved in running the company. If you hire a contractor, you contractually agree how you will pay them usually either timeline or milestone based. You don't have to worry about any taxes being withheld. At the end of the year, you’ll create a 1099 form to give them so they can include the income in their personal tax returns. You’ll also need to send one to the IRS. If you decide to go with contractors, make sure the consulting agreement assigns IP to the company. Employees will expect to have a set salary, company equipment and set working hours. They will have less autonomy over decisions on how they build or do their work. Employees are required to be paid minimum wage. Paying employees is more complex than hiring a contractor. The company pays employees, withholds taxes on their behalf and pays them to the IRS, state and local agencies. There are a lot of calculations and it gets very complex very fast. If you have employees in different states, it's more of a headache because each state has different laws. At the end of the year, the company provides a W-2 form to each employee so they can use it to show how much tax has already been withheld on their behalf and how much income they have. If you decide to hire employees, don’t do it on your own. Use a payroll service provider. A popular company that a lot of startups use is Gusto. We also have lots of local companies providing this type of service. One final note, make sure the employment agreement includes IP agreement. Employee compensation package. Startup founders should consider giving their employees equity. It helps incentivize everybody to work towards creating a successful company. In the early days of a startup, employees are being paid below market rate. Giving them stock in the company is a way to compensate them for that reduction in cash. It's important that you are generous with shares. The people who are going to be employee number one, two and three are hopefully going to be with you for a long time. You want to keep them motivated. The rule of thumb for startup founders is to give ~10% of the company to the first 10 employees, on a sliding scale (employee one gets more than employee two, who gets more than employee three). The way to structure this is to create a stock plan. You can either issue shares or options from that stock plan. The most common is issuing options, which means employees have the option to buy shares in the future but the price is set now. There are some tax consequences with this so please consult with an expert in this area. If you choose this route, make sure you communicate to your employees what they're getting in terms of equity. Make sure you understand the number of shares they're getting and what that represents in terms of percentage of the company.

FINAL THOUGHTS Keep all your documents in a safe place and assign one of the co-founders to be responsible for this. You're going to need them during fundraising, due diligence, acquisitions and many other times. If you don't have them all stored, in signed format, it's just going to make your life really hard. Look over our Due Diligence Checklist to make sure you have everything you need. Fiduciary responsibility. Make sure the money investors have given to you is being spent sensibly. It should be spent on things that have a significant impact and can increase the chances of success for the company. Investors have trusted you with their money to multiply it, not to go off to Vegas or to buy a wine bar for employees. This is not the way to incentivize and keep employees focus and committed. Remember you could potentially face criminal charges.

- the Crew

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