As a startup idea, prototype, and team are being formed, at what point should an entrepreneur formally incorporate the new company?
The company should incorporate as soon as it plans to execute any legal contract
- This inclues investment documents, employee/partner equity agreements, patents, or even a bank account
- However, you do not yet need to incorporate if you just want to build a simple website or even to pitch your early idea to seed-stage Angel investors or potential partners to "test the waters"
What are the three types of corporate structures usually used for a new startup?
C Corporation (or, simply, a "corporation")
Limited Liability Company
What are some general characteristics of a C Corporation?
A C Corp is a taxable entity independent from its stockholders, so stockholders essentially experience double-taxation (first at company, then on personal tax return)
- It may have unlimited shareholders from any country
- It may have many classes of stock
- Its incentive stock option plans may allow employees to defer tax on the equity compensation until the options are executed
What are some general characteristics of an S Corporation?
An S Corp is merely a tax treatment election made with the IRS for an existing C Corp
- Its shareholders may treat the company's profits or losses directly on their personal income tax returns, rather than having the company taxed first as a separate entity as C Corps are
- It may only have up to 100 shareholders
- Its shareholders must only be individual U.S. citizens and cannot be institutions (such as VCs)
- It may have only one class of stock (common)
What are some general characteristics of a Limited Liability Company (LLC)?
An LLC is a flexible form of enterprise that blends elements of partnership and corporate structures
- The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation
- Much less administrative paperwork and record keeping than a corporation
In which cases would it make sense to set up a company as an LLC rather than as a corporation?
An LLC generally makes sense if you don't plan to achieve massive hockey-stick growth and/or if you don't plan to raise much outside funding
- Consulting companies are a standard example of an LLC-suitable business model
- That said, it is not very difficult to switch to a C corp later, if you want to start as an LLC
When should you choose to become an S Corporation rather than a standard C Corporation?
If founders want the benefit of flow through tax treatment with respect to losses prior to an outside financing, and if that outside financing is not planned to be executed in the immediate future, then an S Corp election may make sense
Your S Corp election can be very easily revoked at the time of a Series A financing, thus automatically switching you to a C Corp.
In what state should you incorporate your company if you intend to ever seek venture financing, and why?
Delaware is generally the best state in which to incorporate a high-growth company
- Institutional investors often insist on it
- Its body of corporate law is the most developed & efficient
- Both investors and entrepreneurs are afforded fair & equal protections
Why should you be sure to officially issue founder equity (or options) long before you accept money from outside investors?
For tax reasons, it is important to issue founders' stock ASAP so you can price it a par value of $0.01
- If you instead issue founder equity too close to the date of an incoming investment, the IRS may choose to ascribe a much higher valuation to the founders' stock, thereby forcing the founder to pay heavy taxes on it this year
- (Note: This does not apply to seed financing being raised in the form of convertible debt.)
- Once you have raised your first priced equity round, you can only issue stock *options* (not founders stock) if you want your new employees to avoid immediate taxation
What does "vesting" mean, when referring to equity or stock options?
Vesting is the process by which ownership of equity (or rights to options) matures
If the holder of vested shares leaves the company before his shares are fully vested, then the company has a right to re-purchase those shares (or a portion of them) before they have their full chance to grow in value.
Should the shares of a startup's founder vest over time, or should they be issued to the founder as direct equity with no vesting provisions?
Even the startup's founder(s) should have their stock vest
- This protects investors and other team members from the founder(s) leaving the company early but taking with them a large percentage of the stock as "dead equity"
- Incoming investors will generally demand for a startup's founders' equity to be on a vesting schedule
What is a "Cap Table"?
A Capitalization Table, or "Cap Table," is a neat summary of how the equity in a company is distributed
It lists all the shareholders & number of shares they own (in each class of stock), as well as all warrants & options issued.
Does a newly incorporated startup need to have a set of bylaws?
A startup should always draft a set of bylaws immediately after forming the company
- These are generally pretty standardized for startups and simply lay out Board rights, voting procedures, and other basic governance provisions
- Investors and/or government auditors may demand to see your bylaws
- You can find templates online for a low cost
How many shares should be authorized in the initial Certificate of Incorporation?
While states such as Delaware require a minimum of only 3,000 shares, distributable to stockholders in whole 1-share increments, it is generally advisable to authorize & issue several million shares (e.g. 10 million)
This allows for greater divisibility and provides greater psychological motivation to employees receiving options.
What is an NDA, and when are they used?
A non-disclosure agreement (NDA) is a document typically signed by two parties when one is about to disclose private information, such as a business pitch or proposal, to another party
- An NDA prohibits the assigned party (or both parties) from sharing information acquired in the discussions with other outside parties
- VCs and savvy angel investors typically do not sign NDAs, and many even see entrepreneurs' NDA requests as a sign of weakness (if you're worried that your idea would be so easy to replicate, then why should I invest in you?)
What is an "Exit Strategy", and why is it so important to investors?
An Exit Strategy is a company's plan to create a Liquidity Event for its investors
Typical Exit Strategies include intentions to sell to a particular company at maturity, or plans to grow huge and eventually become a publicly traded company with a large IPO.
Is it OK not to have one clear Exit Strategy?
- Savvy investors generally see multiple exit opportunities as a positive thing
- However, it is still important that - when asked about your Exit Strategies - you still have clear explanations of how/why you could easily pursue each one