Lecture 18 - Legal and Accounting Basics for Startups (Kirsty Nathoo, Carolynn Levy)

Name: Lecture 18 - Legal and Accounting Basics for Startups (Kirsty Nathoo, Carolynn Levy)
Uploaded: 2014-11-20T23:56:48.000Z
Duration: 1 h 36 min 19 s

Introduction to Startup Mechanics

Overview of the Lecture

The lecture is presented by Christine and Caroline, focusing on finance and legal mechanics for startups.

They aim to address basic legal and accounting issues that startups may encounter in their early stages.

Importance of Understanding Basics

Founders should not get bogged down in details but must understand essential concepts to avoid pitfalls.

Knowing the basics allows founders to focus on growing their company rather than worrying about legalities.

Legal Entity Formation

Establishing a Separate Legal Entity

A startup must be formed as a separate legal entity to protect founders from personal liability.

Key considerations include determining leadership roles and equity distribution among founders.

Choosing the Right State for Incorporation

Delaware is recommended for incorporation due to its clear laws and investor familiarity.

Investors prefer Delaware corporations, simplifying diligence processes during funding rounds.

Risks of Incorrect Formation

Case Study: LLC Conversion Mistake

A startup initially formed as an LLC in Connecticut faced significant issues when attempting to convert to a Delaware corporation.

A crucial mistake during conversion led to costly legal complications, highlighting the importance of proper formation procedures.

Takeaway on Simplicity

Keeping the incorporation process simple can save time and money; complexity often leads to errors.

Steps for Setting Up a Corporation

Initial Setup Process

To set up a Delaware corporation, founders need only fax two documents, creating a shell company.

Completing Required Documentation

After initial setup, additional documents are necessary:

Approving bylaws,

Establishing a board of directors,

Understanding Company Ownership and Equity Allocation

Individual vs. Company Representation

Founders must differentiate between actions taken as individuals and those on behalf of the company, which is a separate entity. This distinction is crucial for decision-making and ownership considerations.

Importance of Incorporation Services

Utilizing services like Clearkie.com can streamline the incorporation process by providing standard documents, allowing founders to focus on their core business activities rather than paperwork.

Document Management

Founders should keep signed documents in a secure location, as they are vital during high-stress situations such as fundraising or acquisitions. Poor document management can exacerbate stress during due diligence processes.

Equity Allocation Fundamentals

When discussing equity allocation among co-founders, it’s essential to recognize that execution holds more value than the initial idea; thus, equity should reflect contributions fairly rather than disproportionately favoring the idea originator.

Equal vs. Disproportionate Equity Splits

While equal equity splits are often ideal for team cohesion, significant disparities may indicate underlying issues within the founding team regarding trust and commitment levels to the startup's future goals. A lack of equality could signal unresolved conversations about expectations and contributions among founders.

Long-term Commitment Considerations

The focus should be on each founder's long-term commitment to the startup rather than past contributions or who originated ideas; this fosters a collaborative environment necessary for successful execution moving forward.

Formalizing Stock Ownership

Stock Purchase Agreements and Vesting Explained

Understanding Stock Purchase Agreements

A stock purchase agreement involves an individual buying shares from a company, representing a two-way transaction where payment is exchanged for ownership of shares.

Shares acquired may be in exchange for cash or contributions such as intellectual property (IP), inventions, or code, ensuring the company owns all past contributions.

Importance of 83(b) Election

The 83(b) election is crucial; failure to file it can jeopardize deals and has caused significant issues in the past.

This election impacts both individual and company taxes, making it essential to sign the stock purchase agreement and file the 83(b) election with proof of submission.

Concept of Vesting

Vesting refers to gaining full ownership of stock over time; if an individual leaves before vesting is complete, unvested shares can be reclaimed by the company.

Common terminology includes "restricted stock" for shares subject to vesting and "shares subject to forfeiture" in IRS terms.

Typical Vesting Period

In Silicon Valley, a standard vesting period is four years with a one-year cliff: after one year, 25% of shares are vested, with remaining shares vesting monthly thereafter.

If a founder leaves before completing one year (the cliff), they receive no vested shares. Leaving just after one year results in owning 25% of their shares.

Repurchase Mechanism

When founders leave, companies can repurchase unvested shares at the original price paid by the founder—essentially returning their investment.

Reasons for Implementing Vesting

Vesting prevents significant equity loss when founders leave unexpectedly; it ensures fairness among remaining founders who continue working on the startup.

It incentivizes founders to remain committed to their startups since they cannot walk away with full ownership immediately.

Single Founders and Culture Setting

Even solo founders should implement vesting as it demonstrates commitment and sets an example for employees regarding shared long-term goals.

Having vesting aligns incentives among all team members and reassures investors that founders are dedicated to growing the business.

Key Takeaways on Equity Ownership

Vesting aligns incentives: All founders must contribute over time before receiving equity benefits.

Raising Money: Understanding the Process

The Need for Funding

Companies often reach a stage where they need to raise money, which involves understanding both tactics and paperwork.

There are two primary methods of raising funds: setting a price (valuation) or not setting a price.

Types of Rounds

Seed rounds typically indicate that the price has not been set, while Series A or B rounds imply a predetermined valuation.

Unpriced rounds usually involve convertible notes or safes, allowing investors to invest now and receive stock later when the company’s valuation is established.

Investor Rights and Evaluation Caps

At the time of investment paperwork, investors do not become shareholders and lack voting rights but may have other rights discussed later.

An evaluation cap is crucial; it sets an upper limit on future valuations for converting investments into shares.

Example of Investment Conversion

For instance, an investor putting in $100,000 with a $5 million cap would receive more shares than one investing at a $20 million valuation during a priced round.

Considerations When Raising Funds

It's essential to keep track of signed documents as different investors may have varying rights.

Be aware of potential dilution; raising significant amounts can lead to losing substantial ownership percentages in your company.

Sophisticated Investors

It’s vital to attract sophisticated investors who understand startup risks rather than casual acquaintances who might cause issues later due to their financial expectations.

Key Takeaways for Fundraising

Understanding Investor Requests

Common Investor Requests

Founders often express confusion about agreements with investors, highlighting the importance of understanding investor requests.

Investors may request a board seat to monitor their investment or provide strategic guidance; founders should be cautious and ensure any board member adds real value.

Many individuals offer advice to startups, but not all provide valuable insights; an investor's role as an advisor should not require additional compensation beyond their investment.

Celebrity investors frequently seek advisory roles post-investment, sometimes requesting shares for these services, which can be seen as seeking extra benefits rather than genuine support.

Pro-rata rights allow investors to maintain their ownership percentage by purchasing more shares in future funding rounds, helping them avoid dilution.

Understanding Pro-Rata Rights

Pro-rata rights are essential for preventing dilution when new shares are issued; they enable early investors to keep their ownership stake intact during subsequent financing rounds.

Founders must understand pro-rata rights thoroughly since they can lead to greater dilution for themselves compared to the investors who hold these rights.

Information Rights and Communication

Investors typically want contractual information rights that allow them access to company updates; regular communication is encouraged but should not become excessive or intrusive.

Monthly updates are beneficial for fostering relationships with investors and soliciting assistance, while overly frequent demands from investors (like weekly budgets) can be problematic.

Managing Business Expenses After Funding

Importance of Business Expenses

Once funding is secured, companies begin incurring business expenses necessary for operations such as employee salaries and office rent; these costs are tax-deductible.

Non-business expenses cannot be deducted from taxes and may increase taxable profits; maintaining clear separation between personal and business finances is crucial.

Responsible Use of Investor Funds

Founders must use investor funds responsibly, focusing on business success rather than personal expenditures; misuse of funds can lead to severe consequences.

Understanding Business Expenses and Founder Employment

Importance of Tracking Business Expenses

When spending investor money, founders should be prepared to justify each expense. If any line item would cause embarrassment, it likely isn't a legitimate business expense.

Founders often operate at high speeds without focusing on bookkeeping; however, it's crucial to keep receipts for accurate accounting when engaging with a bookkeeper or CPA.

Bookkeepers will need the founder's assistance in identifying which expenses are business-related, emphasizing the importance of organized documentation.

Legal Obligations of Founders

Founders must recognize that their company is a separate legal entity; thus, they are employees and must be compensated accordingly. Working for free is illegal.

Companies are required to pay payroll taxes. Ignoring these obligations can lead to severe consequences, including potential jail time for founders who neglect them.

Investing in a payroll service is advisable for startups to ensure compliance with tax laws while maintaining lean operations by avoiding excessive salaries.

Managing Founder Breakups

A "founder breakup" occurs when one co-founder is asked to leave the company. This situation can become complicated if unpaid wages are involved.

Unpaid wages can serve as leverage during disputes, leading to demands such as vesting acceleration from the departing founder.

Remaining co-founders may feel pressured into agreements that benefit the fired founder, potentially resulting in ongoing complications within the company structure.

Hiring Employees: Legal Considerations

As startups grow, hiring employees becomes necessary. Understanding employment laws is critical to avoid legal pitfalls during this process.

It's essential to distinguish between employees and contractors due to different legal implications and IRS regulations regarding classification and taxation responsibilities.

Contractors typically have more autonomy over their work hours and methods compared to employees who follow company directives closely.

Understanding Employee Compensation and Termination

Employee Compensation Basics

Companies must provide a copy of tax documents to the IRS for employee compensation, which is essential for personal tax returns.

Employees receive a W-2 form at year-end, detailing their earnings and taxes withheld by the employer.

Founders and employees must be compensated fairly; in San Francisco, this equates to approximately $2000 monthly as minimum wage.

Employers are required to have workers' compensation insurance, especially in states like New York where penalties can be severe for non-compliance.

It’s crucial for employers to verify that employees are authorized to work in the U.S. using a reliable payroll service provider.

Importance of Payroll Services

Utilizing a payroll service provider can alleviate administrative burdens and prevent costly mistakes related to employee payments and compliance.

A founder's failure to set up proper payroll services can lead to significant issues, emphasizing the importance of professional assistance.

Best Practices for Firing Employees

The Necessity of Professionalism in Terminations

Firing an employee is often seen as a rite of passage for founders; it signifies professionalism over personal relationships.

Quick action is advised when terminating an underperforming employee; procrastination can harm team morale and business performance.

Effective Communication During Termination

Clear communication is vital during terminations; avoid excuses or apologies—state the decision directly without ambiguity.

Conduct termination meetings face-to-face with a witness present to ensure transparency and support.

Legal Obligations Post-Termination

Employers must pay all wages and accrued vacation immediately upon termination as per legal requirements.

Access to company systems should be revoked immediately after termination to protect sensitive information.

Key Takeaways on Company Legitimacy

Establishing Company Foundations

To build legitimacy, startups should adhere strictly to standard practices while maintaining organization in operations.

Equity ownership documentation is critical; founders need clarity on financing agreements they enter into for future planning.

Understanding Key Metrics for Startups

Importance of Knowing Your Financial Position

Founders should always be aware of key financial metrics, including cash position and burn rate, to effectively communicate with investors.

Running a company involves serious responsibilities that go beyond the glamorous portrayals in media; understanding finances is crucial.

When to Engage Accounting Services

There are two types of accounting services: bookkeepers for categorizing expenses and CPAs for preparing tax returns.

In early stages, founders can manage bank statements themselves, but will need a CPA at some point during the first year for annual tax return preparation.

Finding the Right Accountant

Recommendations from trusted sources are vital when searching for an accountant or CPA familiar with startups.

Avoid relying on general recommendations; seek professionals experienced in startup environments rather than those unfamiliar with such contexts.

Budgeting for Legal and Accounting Needs

Incorporation Costs

Founders should not overspend on incorporation; online services like Clerky offer affordable options in the hundreds rather than thousands.

When to Hire a Lawyer

The necessity of hiring a lawyer depends on business complexity and specific needs such as privacy policies or fundraising terms.

Cost-effective Legal Solutions

Basic fundraising documents can be obtained at low costs (under $100), which helps minimize legal fees during initial funding rounds.

Challenges with Cryptocurrencies in Fundraising

Navigating Cryptocurrency Regulations