Lecture 18: Legal and Accounting Basics for Startups
startupclass.samaltman.com
startupclass.samaltman.com
The simplest option for founders is to incorporate in the state in which they reside/plan to conduct business as they are going to have to file as a foreign entity in that state anyway.
The retort is "But investors won't invest in my California LLC!" The first fact this argument overlooks is the that most companies are never able to raise institutional capital. So incorporating in another state for investors you don't have is entity selection's form of premature optimization. Investors look to invest in promising businesses; they aren't seeking out investments in Delaware companies.
The second problem with this argument is that it pretends entity selection can't be easily revisited. It can. As I have pointed out before[1], converting to a Delaware corporation is generally a straightforward process. If you have a California LLC, for instance, and need to convert to a Delaware C corporation, it is unlikely to be anywhere near the most complicated or costly part of a financing.
Telling founders they don't need to understand legal and accounting nitty gritty and that they should just follow boilerplate advice ("form a Delaware C corp") is in my opinion bad advice. Understanding the details and why you're doing something won't guarantee that you build a great business, but it can save a great business from legal, tax and accounting mistakes that can be fatal.
But if you're not, consider when you have an interested potential investor who's mulling over your business model and asks offhandedly, "So you're a Delaware C-Corp, right?" and you answer with this.
Then he thinks: "if they didn't even get this right, what else have they missed?"
And you lose the deal.
I would be more suspicious of a founder that spends too much time getting their incorporation just right - for businesses that are going to raise institutional capital, that's really the least of your concerns.
Do you have a few sources to back up this claim?
I think you need to consider the target audience of the presentation - it's for people who want to start high-growth tech companies that will raise venture capital. If that's your goal, then the simplest option by far is to incorporate as a Delaware C-corporation. On the other hand, if a larger goal for you is to save a few hundred bucks a year on the extra franchise tax, then yea - maybe you want to incorporate in your home state. But then you're not the intended audience for this presentation or the advice contained in it.
I'd also just point out that telling people to just incorporate in their state of residence is no less boilerplate advice than telling people to incorporate in Delaware :)
Correction: it's for people who have been convinced (or are in the process of being convinced) that they're starting high-growth tech companies that will raise venture capital.
Just because you immerse yourself in Silicon Valley culture and create a "startup" does not mean you actually have a high-growth business, or that you're going to raise capital from institutional investors. The vast majority of "startups" never achieve high growth, and venture firms reject far more companies than they fund. If you have a great business worth funding, no institutional investor is going to walk because you may need to revisit entity selection.
> I'd also just point out that telling people to just incorporate in their state of residence is no less boilerplate advice than telling people to incorporate in Delaware :)
I didn't advise that founders incorporate in their state of residence. I stated that this is the simplest option. And it is. That doesn't mean there aren't situations in which the simplest option is not the best option, but if you're going to rule out the simplest option, you should understand why doing so makes sense.
2. Incorporating a Delaware C-corporation is by far the simplest option for high-growth tech startups. As an attorney in Silicon Valley, I cringed every time I had to deal with some other type of entity because it just wasted a lot of time (and thus the client's money) figuring out stuff that is muscle memory for Delaware C-corporations. And it always is painful to see the horror stories, like the one mentioned in the lecture. It's experiences like that that lead startup lawyers to advocate just going with the beaten path. All the extra headache is just not worth the few hundred dollars you save in franchise taxes. Penny wise, pound foolish.
No offense, but this says more about your experience than it does about California corporate law. When you have a hammer, everything is a nail. Just because you worked at a full-service law firm that primarily deals with companies incorporated in Delaware doesn't mean that your experience represents all attorneys.
Maintaining a California corporation is not rocket science. There are plenty of competent, experienced attorneys in California who have "muscle memory" when it comes to California law.
Since most high-growth tech companies, at least in the US, are Delaware C-corporations, the lawyers that specialize in those companies are going to be most familiar with Delaware C-corporations.
Do these lawyers have to be at large law firms? Nope, as you mentioned, there are plenty that are out on their own or are at smaller firms.
The number of companies that actually achieve high growth and have high-growth company legal needs is small, as is the number of startups that raise institutional capital. Heck, lots of companies struggle and fail to raise any funding at all. Of those that raise seed funding from angels, the majority will not be able to secure a real Series A.
Structuring your entity and selecting an attorney on the assumption that you're starting a high-growth enterprise before you are anywhere close to having one is like spending all of your time and money trying to architect a web application that can support a billion users before you even have your first 100. It's premature optimization plain and simple.
On that point, I have never met an entrepreneur who failed because he or she didn't incorporate in Delaware or retain a "startup attorney" with a fancy office on Page Mill Road. I have met plenty of entrepreneurs who have failed in part because they took on certain expenses prematurely based on misguided assumptions and rosy projections.
You don't have to get an attorney with a fancy office on Page Mill Road. But even if you did some big law firm, you would probably get a fee deferral that covers formation, so you're not out of pocket anything anyways.
Know your anonymous on HN but would love to hear your thoughts on emerging startup tech company funding models and which, if any, you like? Revenue-based financing as one example.
Ping me at asanwal(at)cbinsights(dot)com if interested and we can set up time to chat.
Thanks again for all the great contrarian (for HN) comments.
If you're running a lifestyle business that never has any corporate legal activity then maybe it won't matter, but I think most folks would be better off minimizing legal fees (measured in hundreds per hour) instead of taxes (measured in hundreds per year).
I never suggested the entity selection issue boiled down to taxes and taxes alone.
You seem to be under the impression that matters of corporate law are a lot simpler than they actually are. This article[1] explains why that's not always the case. Bottom line: incorporating a California-based business in Delaware doesn't necessarily allow you to avoid the California Corporations Code.
If you operate a startup based in California, the majority of which is owned by California residents, you are absolutely not going to see your legal costs reduced by incorporating your California-based business in Delaware.
[1] http://www.lexisnexis.com/legalnewsroom/corporate/b/business...
Representing a DE company based in CA is the default for corporate lawyers in SV - being incorporated in CA is a complication that forces your lawyer and opposite counsel outside the normal groove.
By "reputable startup attorney in Silicon Valley" I assume you mean a partner at any of the brand name full-service law firms that bill associates out at $400-500/hour for cookie-cutter work (like Delaware incorporation). My SO is a Biglaw attorney so I know how the game works.
You can easily find highly-experienced solo attorneys, many of whom have Biglaw backgrounds, or small firms run by experienced attorneys, who offer their services at hourly rates below the rate an inexperienced second year associate at a Palo Alto Biglaw firm is billed out at.
So I'll suggest a different question: ask any honest attorney whether it's net-efficient to retain a Biglaw firm before an individual has a real business.
I don't know where your SO works, but most biglaw attorneys in Silicon Valley view formation work as a loss-leader. It's not where the money's at.
And you definitely don't need to have a biglaw lawyer to form a Delaware C-corporation.
I don't have anything against Biglaw. There is a place for the large full-service firms. But I can retain one at any time. At the earliest stages of a company, incorporating in Delaware "because VC" and retaining a Biglaw firm "because success" is just foolish for the average entrepreneur, especially young first-timers who have a high likelihood of failure. Entity selection is usually easily revisited, and you can get high-quality legal counsel at a fraction of the Biglaw cost.
I worked without pay for 6 months. I had no indication anything was wrong. We raised a seed round were about to finally start paying ourselves the cofounders booted me. Suddenly they weren't happy with my performance, though days before they'd praised it. Worst of all one of them still hadn't quit his full-time job!
The vesting cliff protects those who stay from a founder leaving early, but it also creates the possibility of a founder getting strategically booted once the business is less risky and/or starts getting traction. To be perfectly honest after going through this, I'm not very inclined to do a founder vesting cliff again.
A cliff still makes sense in cases when a cofounder abandons a start-up and stops working. Maybe the safest way for everyone involved is to only apply cliffs for the first 3 months or in the case of voluntary departure. That still leaves room for abuse but at least the temptation is more limited.
I'm sure the folks at YC have experience with just about every permutation of this scenario. I wish the video had also covered protecting the founders on the other side of a split up.
I wouldn't have a 1-year cliff for any below-market employees. I'd reserve 1-year cliffs for employees with market salaries that happen post-funding.
When you finally do get a lawyer or accountant down the road, the advice you receive will have good context.
Tech analogy: it's easier to build a website for someone who understands what a "CTA" is.
Do people have thoughts about this? It seems to me that this area is generally somewhat opaque, with many people on either side being reluctant to discuss it honestly for various reasons (founders might want employees to think that a pittance is reasonable, employees might embellish when talking to others, etc).
What do you do if you just want to be fair? What do you do differently for employees #1 and #2 vs #10, #20, etc (assuming you ever get that big)? How do you adjust for differences in expected value of the employee to the company (e.g. recent grad vs. senior "executive" type with valuable industry connections)?
When should you allocate an employee equity pool and how do you size it appropriately?
You can check out my top quotes from the lecture summarized here: https://medium.com/@RajenSanghvi/59-quotes-from-kirsty-natho...
Yes.
> If not, how do $1/year salaries work?
It depends on each state's regulations.
Or in the legal sense, it's an item of token value.
"Substantial" in this context depends on the facts and circumstances. Generally, anything less than double-digit % ownership is not substantial enough, unless the company is worth well into the millions.
As somebody who knows basically nothing about any of this, I found this statement confusing. Don't minimum wage employees break this rule by definition? So what subset of "employees" does the rule apply to?
The difference between the two:
http://career-advice.monster.com/salary-benefits/salary-info...
And California-specific regulations:
http://www.calchamber.com/california-employment-law/Pages/ex...
I guess that's as good an answer we're going to get to the Dropbox question (at least until they IPO).
But, but, but: It looks like there is a kind of a bus or bandwagon, and after this lecture I'm thinking of either not getting on or just jumping off before going too far.
Sure, YMMV.
More generally, I'm concluding that for information technology start-ups, Silicon Valley equity funding is on a long walk on a short pier, about to go the way of the Dodo bird.
E.g., the lecture told me that the Silicon Valley way is awash in onerous, nearly intolerable, often seriously dysfunctional, financial, legal, organizational, etc. overhead that is unnecessary and should be dumped into SF Bay and forgotten about.
Instead, with some irony, I remember the advice of Ron Conway in Lecture 9
http://startupclass.samaltman.com/courses/lec09/
in praise of bootstrapping.
My view: Be a solo, technical founder. Plan the start-up; get a computer; write the software; own 100% of the business; organize as a Sub-chapter S or LLC; get users/customers and revenue; do not accept equity funding; grow the business; smile all the way to the bank; and totally just f'get about VC, liquidation preferences, pro-rata rights, vesting, reporting to a board of directors, a Delaware corporation, etc.
Vesting: That's where a solo founder who owns 100% of a business -- and it's got to be a pretty good business before it qualifies for VC equity funding, e.g., see (5) below -- has the business take an equity check and suddenly owns 0% of the business, to start to get back some ownership gets a four year vesting schedule with a one year cliff, takes on a lot of expensive, onerous overhead, and reports to a BoD with people with a fiduciary responsibility to (themselves and) their limited partners, that can fire the founder for any reason or no reason (thus costing the founder his unvested stock -- do that in the first year and the founder gave his business away to the investors for a small salary for a few months and $0.00) who are non-technical and the founder would not want to hire in the business, who do not write code, who commonly claim they have "deep domain knowledge" (an outrageous belly laugh) and, really, do not understand the business. Total bummer.
To me, if a well qualified technical founder believes that he needs co-founders and/or equity funding, then, instead, he should think of a better business idea that doesn't need those and that he can do as a solo founder.
Some really good news: The US is just awash, border to border, crossroads, villages, ..., to the biggest cities with successful businesses 100% owned by solo founders. Indeed, from all I've seen, it is mostly just such founders who own houses, vacation houses, super-cars, boats, and jewelry worth $1+ million each and pay full tuition for K-12 private schools and Ivy League colleges. E.g., own 10 fast food restaurants, several new car dealerships, a good independent insurance agency, be a successful dentist, have a good construction firm of larger buildings, own and rent real estate, etc.
Further, actually can do fairly well in coin laundries, pizza shops, Chinese carry outs, landscaping, ..., even just grass mowing and snow plowing.
And of course these solo founder Main Street, USA businesses nearly never have VC or even equity funding.
Even better news: What can be done in principle, and sometimes in practice, with a computer that costs $2000- and an Internet connection with upload speed of 25 Mbps is just staggering, nearly beyond belief. E.g., there was the Canadian romantic matchmaking start-up Plenty of Fish, long just one guy, two old Dell servers, ads just from Google, and $10 million in annual revenue.
Five points:
(1) For more, a big lesson of the Altman course, YC, and VC is that there is a big risk of disaster from co-founder disputes but also a big theme of don't be a solo founder. Maybe there are some good reasons investors don't like solo founders, but I can see big reasons well qualified technical founders should want to be solo founders.
(2) For more, this latest lecture and much more, e.g., John Doerr from KPCB, keep saying that ideas are easy, plentiful, and worthless and that execution is challenging, risky, and everything.
My version would be, good ideas are challenging, rare, valuable, and nearly everything and, given a good idea, execution is routine and reliable.
It appears that Silicon Valley (SV) believes that an idea is just some one sentence product description a founder might explain to his neighbor and regards everything else as execution. So, it appears that SV fails to understand what else should be in a good idea. No wonder on average VC has poor ROI:
http://www.avc.com/a_vc/2013/02/venture-capital-returns.html...
But a good idea might be based on some original research, secret sauce, challenging for others to duplicate, and be protected as a trade secret or with a patent. Some people believe that some trade secrets and patents are valuable assets, maybe just crucial to the business, and not easy, plentiful, or worthless.
So a founder wants to report to a BoD that believes that ideas are worthless? What about some original and solid ideas for much more effective ad targeting? Easy? Worthless? Gads.
(3) For more, VCs keep saying that a start-up that claims that they have no competition is just silly, that there is always competition or at least near substitutes. Let's see: What about the original Xerox 914 copier, a license to print money?
(4) For more, there is the common claim that whatever a start-up is doing, it is not the first. Hmm .... Suppose we take the set of all efforts that did the same thing and there consider the effort that was started with the earliest date. Then that effort contradicts the claim.
(5) For more, some of the VC arithmetic doesn't work out:
E.g., once Menlo Ventures wrote me that they would not consider an investment in my work before I had 100,000 unique visitors a month. Okay, assume (a) each month, on average, each unique visitor comes 5 times and each time sees 8 Web pages, (b) each Web page has on average 4 ads, and (c) get paid $1 per 1000 ads displayed. Then the monthly revenue would be
100,000 * 5 * 8 * 4 * 1 / ( 1000 ) = 16,000
But the CapEx to serve 1 million uniques a month? Let's see:
That would be an average of
1 * 10**6 * 5 * 8 / ( 3600 * 24 * 30 ) = 15.4
30 * 2000 = 60,000
I can understand that a start-up with 100,000 unique visitors a month and five co-founders, each with a pregnant wife, might very much want some equity funding. So, be a solo founder.
In simple terms, by the time a solo founder has a business of interest to VCs, he has high motivation just to continue to own 100% of the business and f'get about equity funding.
With points (1)-(5), I see a pattern: Denigrate founders.
Net, I'm missing why good technical founders should want to be on that bus.
Yes, YMMV.
The core value proposition of VC equity funding seems to me is enabling the business in the first place, or at least taking the business to places it could otherwise never reach. Obviously, there are lots of cases where that simply isn't necessary - and nobody likes to take on unnecessary equity holders if they don't need the money.
But if you do need the money, it's not a surprise this comes at a cost. People who invest in companies want to make sure those companies have a decent shot at succeeding. The vesting scheme is designed to incentivize founders to keep working on their company, and if that looks very similar to vesting schemes early employees get that's not an accident.
The same goes for your more general criticism of SV as a location. There are startups where this is simply not relevant. Nobody wants to move their life and business to another (more expensive) location if they don't expect it to be better there. But for a certain type of startup, the expectation that SV is better than any other part of the world is absolutely justified.
Everything is a tradeoff. It makes sense to evaluate these tradeoffs carefully. Money has a cost. Optimizing your opportunities (usually) has a cost. Sometimes you need investors to succeed, sometimes you don't.
To put it bluntly, if I can become the next Facebook while sitting in my garage in Vladivostok not talking to anybody, there is absolutely no reason to move to Silicon Valley and give away most of my company. That's a big if, though.
1. I am not being critical of the content (well not most of it) as there was lots of valuble information, but the lack of anything other than one perspective of how you should start a start-up.
I'm a soloist by nature, but I've learned that I need to work with others. The mutual support of a qualified partner is almost priceless, for you and for them.
YC, and the startup culture in general, appears to have noted a strong correlation between multiple founders and success. It also sounds like founder breakups are common. These two observations are compatible.
Ideas do have intrinsic potential value, but that value cannot be unlocked without execution. You may have an idea that sequences DNA with absolute fidelity in ten seconds for $1. That idea has an intrinsic potential value of many billions, but if it can't be brought to market (or to proof-of-principle, to sell the idea to others), that value cannot be converted into currency.
The result is, I've just had to do more of the work, say, serially instead of in parallel. That's not all bad: (1) I understand more of the work, really all of it, because I did all of it (the co-founder and I broke off before he contributed anything). (2) I saved time and effort coordinating with a co-founder.
Sure, a VC might say, "That your candidate co-founder didn't do much suggests that he was not really impressed with the project. In that case, neither am I."
But there's another explanation: Often some people just don't want to get along.
To get someone to work reasonably hard, one approach is to have a big, successful company, pay enough to support a wife and family, and have the wife with two young kids and with one more in the oven. Two guys in a garage don't meet this criterion.
I'm plenty motivated; he wasn't. My view is, for as much as he had to bring, still he had some serious flaws in his character.
So, find another co-founder? Not so easy. Easier just to do the work! For a co-founder, some of the usual recommendations are to select someone with good paper qualifications and have known and worked well with for years. Okay, my list of such people is exhausted. So, net, I'm a solo founder.
Again, the US, border to border, from crossroads, villages, and towns up to the largest cities, is just awash with solo founders of successful Main Street sole proprietorships. So, for a business where the initial work is just typing code into a computer to be used as a Web server, being a solo founder seems fully promising to me, even if VCs don't like it.
Facebook has half that revenue per user, and that's with powerful targeting options and a userbase that spends a lot of time on the site/app.
I don't yet know the details of how Web sites get paid for running ads.
Of course, at venture firm KPCB, the Mary Meeker reports commonly claim that a Web site can get paid $2 per 1000 ads displayed -- additional details are missing. In my arithmetic, I assumed only $1 per 1000.
For Facebook, I don't get it: With some irony, for people who saw the movie, I find the f Web site brutal, excruciatingly brutal: I can't make any sense out of it -- I click and click, the response is really slow, and then the screen jumps around to whatever, why, to what, I have no idea. What the heck the "timeline" is, I have seen no definition, can't make sense out of it without some investigation, and don't want to do that. If Zuck wants to have some obscure UI/UX, good for him, but I'm not impressed. There are lots of goofy icons I can't spell, pronounce, look up in a dictionary, see clearly enough to recognize anything, etc.
For ads on f, I don't get it: To me Zuck is running f as some weird thing with little or no interest in ad revenue. If he is getting paid by the click, then so far he's made $0.000000 from me.
My Web site is all about niches, really just niches, for each user who arrives, as in drill down, zoom in, filter out, focus in on a highly personalized niche, for some quite fundamental reasons likely by a wide margin the most finely grained, personalized, niche-oriented Web site on the Internet so far and for a long time in the future.
And, yes, I have some associated ad targeting ideas.
So far, my UI/UX is just simple, dirt simple, childishly simple, about the simplest possible HTML with minimal CSS simple. So, no pull-downs, no pop-ups, no roll-overs, etc.
And, no icons! Wish I could stand on Mount Everest and shout with transcendental ecstasy louder than the blast from Mount Pinatubo "no icons!". Right, you guessed it; oh how you guessed it; I deeply, profoundly, bitterly hate and despise icons! No icons! At last, at last, free at last, no icons!
The screen never jumps for any reason. All the layout is from, right, just tables, with all sizes fixed and exact in terms of pixels.
The UI/UX is simpler than that of HN. ASP.NET writes a little JavaScript for me, but so far I have yet to write a single line of it and am eager to continue this way.
The UI/UX is so simple that a child of 6 who knows no English could learn to use the site in about three minutes just watching an adult, and an adult who knows no English could guess how to use the site in about two minutes. We're talking much easier than, say, Microsoft Word. And since the site is in English, for people who know English, sure, it's still easier to learn.
Each Web page is just exactly 800 pixels wide with high contrast and large fonts. The site should look fine on any device with a Web browser up to date as of about five years ago -- I'm not counting, maybe 10 years ago.
We're talking simple and, thus, really easy to use.
Each Web page sends for about 400,000 bits so that in a Web browser each page should load and format like "boom" or "pop".
Then, on each Web page, there is a banner ad of the standard size 720 x 90 pixels and down the right side an average of about four ads in the standard size of 300 x 250 pixels. And the ads do not get in the way of the utility or hurt the UI/UX. So, we're talking ballpark five ads per page.
Looks to me, page for page sent, compared with f, my pages are nearly a license to print money.
And, per user, the assumptions I made in the arithmetic should be okay for the users that do like my site. And some users, in the word in the movie, will find the site "addictive" -- something like a new game, and more addictive than, say a slot machine. The usage is highly interactive, especially for the part about drill down, .... One candidate early enhancement is a curious way to calculate a reward for skilled usage!
It looks like the main issue will be, will 2+ billion people like the site?
If people do like the site, then it looks like I have a shot at getting more revenue per user per month than f. Also my UI/UX is much easier to use than f! Heck, f's too tough for me! My hat's off to you, Zuck; I can't understand your Web pages or your site.
But thanks for the info on the $1.60. I've been writing software, nearly ready to start polishing and then go live, and collecting some initial data. Details of ad revenue will come later.
Any reason to do a C-corp vs. LLC in that scenario? (Either way I was planning on using Delaware even before watching this video)
http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou...
> Convertible debt with no cap is stupid for investors. Convertible debt WITH a cap is stupid for founders.
> With a cap means that every person who wrote you a check assumed that they were going to pay the cap. So if I write you a $500,000 check into a convertible note with a $4.5 million cap I am assuming when I write the check that I will own 10% of your company. If I didn’t assume this I shouldn’t write the check because I have to get involved knowing that I might pay that price.
> But entrepreneurs – convertible notes have no MINIMUM! So you’re taking all of the pricing risk. This has worked very well in the 2009-2012 time frame because the tech market has boomed in this period. But many convertible-debt companies are starting to feel that pinch now. I’m starting to hear it more often. And then the market does slow down you’re going to hear an entire generation of convertible-debt companies moan.
1. This is assuming that you have not been lent the capital required to the company.
But it also has the benefit of being easier to "switch" to a C Corp later if necessary.
Short answer: it's complicated, but probably C Corp. For the reason that if there's any chance you're going to take angel investment or give stock to employees, you almost need a C Corp. In fact, the lack of a standard C Corp just creates complications with investors and employees that puts you at risk. Keep it simple.
*
C Corporations are almost necessary if you are planning on taking investment. They are not as tax-efficient as LLCs because they're taxed twice (once at the corporate level, and another time at the personal income level / capital gains level depending on whether $ is paid out via salary or dividend.) However, they come with the benefit of having different classes of stock (usually required for investors / employee stock options).
LLCs are pass-through entities. They reduce taxes for shareholders by basically eliminating payroll / capital gains taxes.
If you have an LLC and want to take investment, it is relatively straightforward to convert to a C Corp if its early enough in the company's lifespan.
On the other hand, converting from a C Corp to an LLC is a pain (you have to create a separate LLC and have it buy the assets of the C Corp, which creates a taxable event).
An s-election is a good option to reduce tax-liability of a corporation. It grants pass-through status. However, to be eligible, you have to file in the first 75 days of the year, you can only have common stock, and all shareholders have to be US Citizens (no LLCs, etc).
My intent is to get our saas product out and start charging through our website. So, I was thinking that forming an LLC is the cheapest way to get there. Spending several thousand dollars to form a C-corp seems too much at this point. http://www.quora.com/How-much-does-it-cost-to-set-up-a-C-cor...
Please do not use RocketLawyer or something similar. They are super cheap, but they only create a shell C Corp. I made that mistake which luckily wasn't costly to fix.