Last Updated: 20 Jan 2015

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Author: dordal

Basics of Founding a Company - 2014

If you're starting a new startup, there are several things that you want to do right from the beginning, especially if you're looking for investment. This doc outlines the process I went through in February 2014. Depending on when you're reading this, things may have changed.

Broadly, things break down into four categories:

  • Forming the Business Entity
  • Issuing Stock (to founders and others)
  • Handling IP
  • Raising Money

The Business Entity

The first order of business is to actually form a business. There are any number of ways you can do this, but if you're starting a new company, you'll want a corporation, and a Delaware C-Corp at that. The reasoning:

  • There are quite a few types of entities, such as corporations, LLCs, and even sole-proprietorships. Many (e.g. an LLC) have significant tax and administrative advantages, but if you're starting a startup, the C-Corp is what you want:
    • C-Corps can have more than one class of stock (S-Corps can't, and LLC's don't even have stock), which is useful for investors, who typically want preferred stock.
    • C-Corps have been around forever, and have a predictable set of case-law behind them. Other entity structures, like the LLC, are newer and have less developed law.
    • Although corporations are tax-inefficient, you'll be expected to have losses for quite some time. Therefore, the tax advantages are negligible.
    • A C-Corp is not a pass-through entity, which means investors don't have to deal with your tax issues personally (or as a firm).
    • A C-Corp can have more than 100 owners, which will be critical down the line. Furthermore, all ownership interests are easy to sell, which will be useful when you hit it big and you and your investors want to sell a stake to someone else.
  • You'll want to incorporate in Delaware, not whatever state you live in, because Delaware has some of the most business-friendly corporate laws, and the court system there is efficient and business-friendly. You'll still have to qualify as a 'foreign corporation' in your home state, but you're officially based in Delaware.

Officers & The Board of Directors

When you form your entity and issue stock, you'll need to choose officers for the company. These are the people who are responsible for the overall operation of the company, and have the power to sign documents, etc. There are three roles that you need to fill initially; these can be held by one person or different people:

  • President: Overall responsibility for the company
  • Treasurer: Handles the money
  • Secretary: Records things for the company, e.g. meeting notes from a Board of Director's meeting.

You'll also need to form a board of directors. For now, it will mostly likely be the officers of the company. When you take investment, you will likely give up one or more board seats to the investors.

Issuing Stock

When you form a corporation, you'll need to issue shares to the corporation, and somebody will need to own those shares. Unless you have investors already, that's usually the founders: You'll need to split up the shares of the company amongst yourselves. How do you do it?

You probably don't want to split things up equally. Although that might appear to be the politically easy thing to do, it can breed resentment down the line. Instead, you should consider each person's time commitment, experience, skillset, and more to determine how much equity each should get. Nathan Whitehouse has a good article at Forbes about the factors to consider when splitting equity.

Vesting

Equity should vest, meaning that you don't get it all the day the company is formed. Instead, you get a portion of it over a period of time. The typical vesting schedule these days is a four year ( 48 month ) vesting with a one year cliff. That means that nobody gets anything for a year, and then at the end of the 12th month they get the first full year's worth of equity. After that, people get more equity monthly. That way, if a founder bails out after six months, they don't get anything.

You may want to put in specific provisions which allow you to accelerate vesting on certain events, such as a change of control (e.g. the company is sold). The most common provision here is 'double trigger' accelerated vesting, e.g. you get an additional year (negotiable) of vested stock if the company is sold and you are fired by the acquiring company.

Number of Shares

The number of shares you authorize & issue can be somewhat arbitrary. First, the difference between authorized shares and issued shares: shares are authorized per the company charter, and it means the board can issue them. Issued shares are those that have actually been issued to an individual or an entity by the board. Authorizing more shares is a pain-in-the-ass; you have to update your company charter and re-file it with Delaware, etc. Therefore, you want to authorize more than you immediately need, and then allow the board to grant those shares with board resolutions.

A good rule of thumb is authorizing ~15,000,000 shares, but issuing ~10,000,000 shares to the initial founders.

Founder's Preferred Stock

You may want to consider setting up Founder Preferred stock ( a separate class of shares; typically Series FF ). This allows the founders to sell shares at the preferred share price, but doesn't carry any of the other rights of preferred stock. What that means is that founders can get some of their money out of the company in a secondary round of financing, which provides liquidity before a company is sold or goes public.

Investor's Preferred Stock

Unless you have investors the day that you form the company ( very unlikely ), you won't issue any preferred stock for investors. However, when you eventually raise a round, your investors will most likely want preferred stock. Preferred stock comes with superior rights to common stock, including:

  • A liquidation preference; e.g. the right to get money back before common stockholders. Typically, a deal might have a '1X non-participating liquidation preference', which basically protects the investor if the company goes south: if there's a firesale, they get their money back in full before the remaining shareholders split what is left over.
  • Veto rights for certain things, such as a sale of company; issuance of new stock, etc.
  • Anti-dilution protection: if the company doesn't do well, it might have to raise more money at a lower valuation than it had previously. If this is the case, anti-dilution protection will mean investors are issued new shares on a pro-rata basis so that they don't end up diluted.
  • The right to designate a certain number of board seats. Having an odd number of people on the board is a good idea, and frequently, you'll see '2-2-1' boards: two founders, two investors, and one outsider.

Pricing Shares

There's an interesting dichotomy when it comes to determining the price of a company's shares. On one hand, you want your shares to be as expensive as possible; this makes your company worth more. On the other hand, you want your (future) employees and other shareholders to be able to recognize the largest possible gain from their ownership of your company. That means you want to keep your share price as low as possible, so that they can acquire shares at the least possible cost, thus increasing their gain. Furthermore, when shares are issued for no cash consideration, the IRS taxes them as ordinary income. That means you have to pay taxes, and you don't want to pay taxes on a high share price.

As an example, if your share price was $0.00001 and you were issued 1MM shares, you'd have $10 'invested'. You'd get taxed on $10 the year you got your shares. Now say that your shares sold for $15 in an acquisition. You'd have a gain of $14.99999 per share, which you'd have to pay in capital gains tax.

Now say your share price was $10 and you were issued 1MM shares. You'd have a whopping tax bill on $10,000,000 of ordinary income! If your company sold for $15 per share, you'd only make $5 per share, and have to pay capital gains on that. So instead of paying the lower capital gains rate on ~$15/share, you'd get to pay it on only $5/share, and have to pay the much higher ordinary income tax rate on the first $10/share.

Preferred stock is generally issued at a ~5X valuation of the common stock. So if your common stock was $1/share at the time of funding, preferred stock would be $5/share. There's no magic number here; this is more of a guideline.

The 83(b) Election

When you form a company, it is VERY important to file an 83(b) election if you have vesting ( which you should ). Normally, if shares vest, the IRS considers the shares to be taxable the day that they vest, not when they are issued. If you recall that shares are taxed at the ordinary income rate when they vest, you may realize the problem: as your company goes up in value, your share price is growing. As it grows, you start accumulating huge tax bills… for example, in the fourth year of vesting, if your share price was $10 and you had 250,000 shares vest that year, you'd owe taxes on $2.5MM. At the 39% marginal tax rate, that's $975,000…. money you almost certainly don't even have on your founder's salary.

The 83(b) election allows you to recognize the entire cost of all the shares as ordinary income today ( when you found the company ) and not as they vest. Thus your entire ownership vests as capital gains if/when you sell the company.

Handling Money

I'd recommend that you DO NOT contribute money to the company in exchange for stock. This creates a problem because it means you're pricing your shares in exchange for specific cash consideration. You want to keep your shares at the lowest cost basis that you can; if you pay for your shares in cash to get money into the company, you'll be having to pay more for them than you want to.

Instead of buying shares, you should make a loan to the company. This is much cleaner; you can expect to be repaid ( or more likely, have your loan converted to equity ) at the first funding round. ( Apparently, in some cases, investors may demand that the loan be forgiven. I'm less enamored with this approach, but I've been told it happens. )

Handling IP

If you're starting a new company, there is undoubtedly some IP ( intellectual property ) which needs to be incorporated into the company. Most likely, you and your cofounders developed this before you started the new business. There are a few considerations here:

First, can anybody else reasonably claim title to the IP? A previous (or current) employer is a big worry; if you work on the search team for Google, and then decide to leave and start your own search engine, you could be in trouble. Google most likely has an agreement with you which says that anything you develop belongs to them, and they won't be too happy with you taking that and going to start a competing company.

Second, you somehow have to get the IP into the company. This is typically done initially in exchange for stock (e.g. you get your shares in the company in exchange for giving up the IP ). When you form the company, you'll sign a Technology Assignment Agreement, which says all IP you've created to date belongs to the company, as well as an IP Inventions and Assignment Agreement, which will detail that all future IP you develop will become property of the company.

Raising Money

And now, the all important part: raising money. You'll likely have two rounds in the first few years; a seed round and (hopefully) a Series A.

Seed Round

The most common thing for the seed round is a 'convertible note'. Rather than pricing your stock early on, when the value of the company isn't really known, you raise money as debt which has the option to 'convert' into equity during the priced round (e.g. the Series A). Typically, a convertible note will have:

  • A maturity date of 12-18 months, which means you'll need to raise money before that date.
  • If you do a 'qualified financing' ( which can be defined, but is typically $2mm or more ) before the maturity date, the loan converts to equity.
  • Typically, there might be a discount on the conversion, e.g. the loan will convert with 20% off the per-share price. This compensates the initial investors for the early risk.
  • These loans frequently have a cap; e.g. a $6MM pre cap. This means that if your pre-money valuation is more than $6MM, the seed investors get to covert their debt as though the cap was $6M.
  • If you don't raise money by the maturity date, the terms typically say 'payment is on demand'. Theoretically, your investors could demand payment at any time, but the loan is to the company, not individuals, so if the company is doing so poorly it can't raise money, there is likely very little money left to pay them back.
  • If you do pay them back, it will be at some interest rate; typically 6% to 8%.

The biggest advantage of a convertible note is that they're easy and fast; your lawyers only have to draft a few standard documents, generally a note purchase agreement and a promissory note. In comparison, a priced seed round can be 3-5 documents. The investors are much more likely to avoid involving their lawyers for a convertible note, which saves considerable time/money.

Series A Round

At some point, you (hopefully) will have enough traction to raise a Series A round. This will be a priced round, meaning that you will negotiate a pre-money valuation for your company ( say $5M ) and then the amount the investors will invest ( say another $5M ). You then issue new shares in exchange for the cash invested; in this case you would double your shares outstanding. After the dilution, you'd have 50% of your company, and your investors would have 50%. Well, 'you' would be yourself plus any other co-founders plus the seed investors… so you personally would have a much smaller percentage.

Getting Started

That's it. Those four things should help you get started on a new venture!

Discussion

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