How to Start a Startup — W09

Legal and Accounting Basics

Here are a few takeaways from Stanford/Y Combinator CS183b — How to Start a Startup — Week 9 lectures.

Lecture 17 : How to Design Hardware Products Hosain Rahman, Founder, Jawbone

Hosain Rahman’s lecture was very informative and detailed however it was too specific to how Jawbone operates so I have not listed any takeaways.

Lecture 18 : Legal and Accounting Basics for Startups Kirsty Nathoo, Carolynn Levy, Partners, Y Combinator

Legal and Accounting Basics

Setting Up

• The easiest place to form your company is Delaware. The law there is very clear and settled and investors are comfortable with Delaware.
• You can either use the services of a law firm or an online service such as Clerky to complete your paperwork. All the paperwork and the signed documents should be kept in a safe place.

Equity Allocation

• The stock should be allocated equally among the founders. It doesn’t have to be exactly equal, but if it’s very disproportionate that’s a huge red flag.

Paperwork

• The founders in order to own their stock have to sign a stock purchase agreement.
• As a result of the stock being restricted and because of vesting an important document called 83(b) election needs to be filed within 30 days. There is no way to go back and fix it.
• Have proof that you sent in your documents. With no proof it just goes into a black hole at the IRS and investors may walk away from a deal.

Vesting

• Vesting means you get full ownership of your stock over a specific period of time. If you leave before the vesting period is over the company can get those unvested shares back. Restricted stock means stock subject to vesting; the IRS speak for this is “Shares that are subject to forfeiture.”
• In Silicon Valley the standard vesting period is four years with a one year cliff, means after one year, the founder vests in or fully owns twenty-five percent of the shares the remaining shares vest monthly over the next three years.
• If a founder stops working at the company the company can repurchase those shares by just writing the founder a check.

Why have vesting?

• If you didn’t have vesting and a founder leaves, a huge chunk of the equity ownership leaves with him or her and that is not fair to the founders left behind.
• Another reason vesting is essential because founders both solo and multiple need to be incentivized to keep working on their startup. If the founder can walk away with his or her full ownership at any point then why stay and grind away?
• Investors don’t want to put money in a company where the founders can quit whenever they feel like and still have a big equity ownership stake in that company.

Raising Money

• There are two ways to raise money. Either the valuation of the company is set for the money that comes in or the valuation isn’t set.
• Rounds can be called anything. When you hear the term seed round, it means that the valuation has not been set. Anything that’s a Series A or Series B is something where the valuation has been set.
• Not setting the valuation is the most straightforward fast route to getting money and it is done through convertible notes or safes. It is a piece of paper that says an investor is paying x amount of dollars now and in return has the right to receive stock at a future date when the price is set by investors in a priced round.
• It’s important to note that at the time the paperwork is complete, that investor is not a shareholder and therefore doesn’t have any voting rights in the company however he may have information rights.

Valuation Cap

• Investors want something in return for putting in money at the earliest, riskiest stage of the company’s life this is where valuation cap comes in.
• The documents for an unpriced round set a cap for the conversion into shares and that’s not the current valuation of the company. It’s an upper bound on the valuation used in future to calculate how many shares that investor is going to get.
• For example, take an investor that invests one hundred thousand dollars on a safe with a five million dollar cap. If a year later the company raises a priced round with a valuation of twenty million dollars, then the early investor would have a much lower price per share about a quarter. Therefore their hundred thousand dollars would buy them approximately four times more shares than an investor that was coming in and putting in a hundred thousand in a Series A priced round. That’s where they get their reward for being in early.

Things to think about when raising money

• Find sophisticated investors meaning they not only have enough money to invest but they also know what they’re doing. They are called accredited investors.
• Understand your future dilution. Say, you raise two million dollars on safes with a valuation cap of six million dollars, then when those safes convert into equity, those early investors are going own about twenty-five percent of the company. And that’s going to be in addition to the investors that are coming in at that priced round who may want to own twenty percent of the company. Already at that point you've given away forty-five percent of the company. Know if this is really what you want?
• If you don’t understand some of the terms and terminology that your investors are using the burden is on you to figure it out. You absolutely need to know how the terms are going to impact your company in the long run.

Common Investor Requests

• Board seat — The investor usually wants to be a director either because he or she wants to keep tabs on their money or because he or she really thinks they can help you run your business.
• Advisors — Once an investor has given your company money, that person should be a de facto advisor sans any official title and more importantly without the company having to give anything extra in return for the advice.
• Pro-rata rights — The right to maintain your percentage ownership in a company by buying more shares in the company in the future. Pro-rata rights are a way to avoid dilution. Dilution in this context means owning less and less of the company each time the company sells more stock to other investors. Say an early investor buys shares of preferred stock and ends up owning three percent of the company once the financing has closed. The company when it raises another round of financing will go to this investor who negotiated pro-rata rights and say, “Hey. We’re raising more money. You’re welcome to buy this many shares in the new round to keep your ownership at approximately three percent.” As a founder you absolutely need to know how pro-rata rights work. Especially because the corollary to an investor having pro-rata rights to avoid dilution is that founders typically suffer greater dilution.
• Information rights — Investors almost always want contractual information rights to get certain information about your company. Giving periodic information and status updates is not a bad thing however be really careful about overreach. Any investor saying they want a monthly budget to give advice or weekly update, that’s not ok.

Just because the type of financing and the valuation has been negotiated doesn't mean that everything else is unimportant. You need to know everything about your financing.

Founder Employment

• The company is a separate legal entity and exists separately from you as founders, as a founder you are really just a company employee and founders have to be paid too.
• Working for free is against the law and founders should not let their company take on this liability. You wouldn't work for free anywhere else, so why is your startup an exception?
• Founder break ups get extra ugly when the founders haven’t paid themselves because unpaid wages become leverage for the fired founder to get something that he or she wants from the company and typically that is vesting acceleration.
• Companies have to pay payroll taxes, you can use payroll services like Zen Payroll for this purpose.

Employees

• If you have employees you’re required to have workers compensation insurance, especially if you’re in New York. Also make sure that you see proof that your employee is authorized to work in the U.S.
• When firing someone fire quickly ideally with a third party present, communicate effectively and pay all wages and accrued vacation immediately. This is a non-negotiable legal requirement.

*Photo by: Kurtis Garbutt