If you set up your startup with the proper paperwork from the beginning, you’ll save yourself a lot of headaches in the future.
It’s definitely one of the less glamorous parts of starting a startup, but filling out the right forms and setting up the right systems go a long way in getting investors and protecting yourself and your business.
As part of Y Combinator president Sam Altman’s How to Start a Startup course at Stanford University, Carolynn Levy and Kirsty Nathoo — Y Combinator’s very own legal and accounting pros — dished out all you need to know to make sure you’re keeping things legal and official on the back end so you can succeed on the front end.
(For more startup advice, check out How to Start a Startup: The Book. It’s the ultimate reference guide to creating a successful tech startup.)
The formation of your business seems like an obvious step, but make sure that it’s not overlooked. You have to start your company as a separate legal entity to protect yourself from personal liability and ensure that all of the money you make belongs to the company.
But how and where do you go about forming this legally-sound corporation? While you can pick any state, Levy says that your best option is Delaware.
“Delaware is in the business of forming corporations,” she said. “The law there is very clear and very settled. It’s the standard.” Also, investors are comfortable with it, so people already understand it. It’s simple and familiar.
Setting Up a Delaware Corporation
It all starts with a fax telling Delaware that you’re creating a company. Then, Nathoo said, “You need to complete a set of documents that approve the by-laws of the company.” These documents create a board of directors by assigning officers of the company. Delaware requires that someone have the title of CEO, President, and Secretary.
You also need to complete documents noting any inventions or code that you as an individual have created for the startup in order to give the company ownership of them. Keep in mind the difference between doing something as an individual and doing it on behalf of the company.
To Get Incorporated
You can work with a law firm, but what they often use with the YC companies is Clerky — an online service that provides all the documents you need to get going with your business.
Also, Nathoo emphasized again and again the importance of keeping your documents in a safe place, because chances are if an occasion pops up where you need them, you’re going to want them ASAP to give to a lawyer or an investor.
When considering equity allocation, Levy says, “Execution has way more value than the idea.” While ideas are important, no one’s going to buy one.
“Value is created when the whole founder team works together to execute on an idea,” she said. “You need to resist the urge to give a disproportionate amount of stock to the founder who is credited with coming up with the idea for the company.”
Going with the rule of thumb on allocation at YC, Levy said, “Stock allocation doesn’t have to be exactly equal. But if it’s very disproportionate, that’s a huge red flag for us.” To investors, it can make your company seem flighty, dishonest, and even self-indulgent. All in all, it just looks like your founders are not in sync with each other.
Levy said this can all be clarified by looking forward and acknowledging among the founder group that everything that happened before the formation of the company shouldn’t matter. No matter whose idea it was, who coded it or who designed it, from the day you formed the company, that’s ground zero.
Buying Stock (Yes, in your own company)
This is not just a given. You do have to sign some papers to get make your stock official.
It’s called a stock purchase agreement and lets you buy part of the company as an individual. You can pay in cash, IP, invention or code, so that basically the company owns what you as an individual have done in the past on behalf of the startup.
Nathoo said, “We also refer to that stock as being restricted because it vests over time.” Since it’s restricted and vesting, you need a super duper important form called the 83(b) Election. Without that form and confirmation that you’ve signed that form, your and the company’s taxes are at stake, as well as any future deals with investors.
For those of you who don’t know, vesting means you will attain full ownership of your stock over a set amount of time.
This means that if you deuce out before you’ve built up that amount of time at the company, then the company can repurchase the unvested shares from you at the same price you paid for them. In Silicon Valley, the standard time for this is 4 years.
Why Would You Vest?
Without a vesting system, if a founder leaves, a big part of the equity ownership is in flux, leaving the other founders up a creek.
But Levy says it’s also because of “the idea that founders need to be incentivized to keep working on their startup.” She said, “If the founder can walk away with his or her full ownership at any point and time, then why would you stay and grind away?”
This applies to solo founders, too, as a way to show investors their commitment but also to show employees. Levy says it’s a culture point that sets a tone for the company.
There are two ways to do it: Priced and Non-Priced Rounds, which means the price (the valuation of the company) is set or the price isn’t set.
Generally, if a startup is in what’s called a “seed round,” the price has not been set. But if they are in Series A or Series B, then the price usually has been set.
Nathoo said, “Not setting the price is the most straight forward, fast route to getting money … This is done through convertible notes or safes.” There’s a piece of paper that says the investor is paying an amount now and in return will get stocks at a future date when the price is set by investors in a priced round. But until then, they’re not a shareholder, which means they don’t have voting rights.
But these seed investors do want some perks for their riskier investment. For example, when the startup goes into priced rounds, that seed investor has the opportunity to buy stocks at a lower price than other investors.
Nathoo says to keep in mind how much of your company you’re giving away, so that you don’t lose the reins once you hit the priced rounds.
She said, “Remember that some money on a low valuation cap is infinitely better than no money at all. And if those [are the] term[s] that you can get then, then take that money. But it’s just something to be aware of and to follow through the whole process, so that you can see where this is going to lead you down the road.”
Also, Nathoo says that family and friend investments of a few thousand dollars here or there usually end up causing the most trouble in the long run because they aren’t familiar with the long-term process. To avoid this, Nathoo said that investors should be accredited: “They have enough money to be able to invest. They understand that investing in startups is a risky business.”
Know the Investor Terms:
Board Seat: If an investor wants to be on your Board of Directors, that means they want to keep tabs on how their money is being spent or they want to give advice on your business, whether you want it or not. Levy says if this request comes up, most times it’s best to say no. “Otherwise make sure it’s a person who is really going to add value.”
Advisers: If an investor has given you money, Levy says they should be a defacto adviser. You shouldn’t be offering up anything extra for the advice. A good investor will want to help you without extra perks.
Pro-Rata Rights: Levy said that these give you the “right to maintain your percentage ownership in a company by buying more shares in the company in the future.” They’re a way to prevent losing ownership each time the company sells stock to investors. Make sure you know how these work.
Information Rights: Sending investors periodic updates is good, but it can be a red flag when investors want weekly updates or frequent budget breakdowns.
This is where that divide between personal and company needs to, again, be super clear.
As Nathoo put it, “If you were working at Google, you would not use a Google credit card to buy a toothbrush and toothpaste.”
Investors have trusted you with a big sum of money to help the company succeed. She said that, admittedly, this line can get fuzzy in the beginning when you’re working from your apartment 24/7. But a good rule of thumb is to think, if you had to give a line-by-line breakdown to an investor of your expenses, would you be embarrassed by any of them? If so, it’s probably not a business expense.
As a founder, you should get paid, and you should file your payroll taxes. Period.
Besides just basic logistics, Levy says it’s important to pay founders because, in the case of a breakup, unpaid wages are a way for the founder who’s being fired to use those unpaid hours as leverage to get something else that he or she wants and isn’t entitled to — like vesting acceleration.
If he gets over on this deal, then Levy said you have a disgruntled ex-employee not only owning shares of the company, but the rest of the company is now kind of working for him. It’s a nasty feeling.
Also, setting up a payroll service is something worth dishing out cash for. But she advises that, when it comes to paying employees, stay lean with minimum wage if possible in the beginning.
When thinking about the proper paperwork for your employees, first consider if they’re actual employees or contractors.
Contractor: They sign an IP assignment agreement. They set their own hours, location, and project goals, and use their own equipment. They sign a consulting agreement, and the company doesn’t pay taxes. Then at the end of the year, they get a 1099.
Employee: They also sign a IP assignment agreement, but the company withholds taxes and the employee receives a W2. Your employees also need to have worker’s compensation insurance and you need to ensure that the person has authorization to work in the U.S. Nathoo suggests services like ZenPayroll to help you take care of that.
This is where things can get messy. But this may be one of the first things you do for your company to prove that you’re in it for the long haul. It means doing what’s right for the company instead of what’s easy.
Levy had some simple bullet points to make sure any firings are handled quickly and professionally:
1. Fire quickly — No good can come of keeping a bad employee on account of procrastination. You’ll only hurt company culture and maybe even lose business.
2. Communicate effectively — Don’t apologize or over-explain. Cut right to the chase, ideally with a third party present.
3. Pay all wages and accrued vacation right away — It’s the law. That’s all there is to it.
4. Cut off physical and digital access — Do this as soon as the person is gone.
5. Repurchase shares — This, too, should be done right away to further cut all ties with the terminated employee.
Complete all of the proper paperwork up front and keep it in a safe place to avoid crazy legal battles or losing an investor in the future on account of disorganization.
With all of your ducks in a row, you’ll be able to make the most of the insights from the previous How to Startup a Startup lectures with the peace of mind that you’re keeping things legal.
You can watch the video and read a transcript of Levy and Nathoo’s lecture here.
Also, if you enjoyed this post, be sure to check out How to Start a Startup: The Book. It’s the ultimate reference guide to creating a successful tech startup.
Featured image was taken from the video of Levy and Nathoo’s lecture at Stanford.