12 Things You Need to Know When Forming Your Startup
This is a quick primer for early stage startups that plan to raise one or more rounds of funding at some point in time. As a busy founder in an early stage startup, it can be tempting to skip the paperwork. Who doesn’t want to dive right into coding, designing, and selling your product or service? However, proper company formation can save you a lot of time, money, and regret.
tl;dr Good company formation is like having a good pre-nup.
When do I need a lawyer and how do I pick one?
You should seek legal counsel before entering into your first agreement with other parties, such as formalizing ownership with co-founders, promising someone equity, incorporating, or fundraising. It’s best to look into law firms that specialize in and have experience with hundreds or thousands of early stage startups. They understand the nuances of the startup world and often provide free consultations or work to start a relationship with you. The NYU Entrepreneurial Institute can provide some recommendations.
tl;dr Get a lawyer who knows the rules to the startup game sooner rather than later.
When should I incorporate?
Incorporating ensures that when you’re conducting activities related to your startup, you’re acting as an agent of an official business entity. Liabilities and obligations, therefore, fall upon the company and do not affect you personally. You should incorporate when you intend for the company to start entering into agreements with people. Agreements include things like services rendered, payments being made, ownership adjustments, and funding. There is a nominal fee for incorporating. Contact the NYU Entrepreneurial Institute for help or more information.
tl;dr Incorporate before the company has obligations to avoid personal liability for them.
What should I incorporate as?
C-Corporations or LLCs both protect you from personal liability, though C-Corps have more formalized regulations and rules. Income from C-Corps are taxed twice - once for the company and again on an individual basis if you pay out dividends. However, most early stage startups don’t have income. While LLCs aren’t taxed as entities, income from LLCs is still taxed on an individual basis. Some investors won’t invest in LLCs since tax liabilities are passed through. LLCs seeking VC investment will likely have to be converted into C-Corps.
tl;dr You can start out as an LLC or a C-Corp, but investors prefer C-Corps.
Where should I incorporate?
Delaware is the industry standard where lawyers and investors are most familiar with the legal nuances. There is a long history of Delaware case law that sets precedent for what to do in specific situations. It’s easier to look to the past to examine previous rulings to quickly resolve legal problems that arise. Incorporating elsewhere runs more risk of a situation being new, resulting in more time and money spent to determine the right course of action.
tl;dr Incorporating in Delaware is like playing a game you know all the rules to.
How is stock issued to the founders?
Stock issuance to founders is formalized as part of the incorporation process. Founders put an nominal capital investment into the company proportionate to how much of the company they own. This can be the amount needed to keep the company going until it gets more money or it can be an amount used as consideration for tax purposes. For companies with low capital requirements, this amount of capital could be $1 or $100. This initial investment is made in exchange for stock, aka equity, in the company.
tl;dr Founders shares are issued as part of the incorporation process.
How much of my company do I own?
A founder’s ownership percentage is equal to the number of shares owned divided by the total number of shares the company has issued. In addition to the shares owned by the founders, there may be shares set aside for employees as part of an option pool. Shares can also be added when new investors buy into the company, diluting existing shareholders.
tl;dr Your ownership is equal to your number of shares divided by the total number of shares.
What is dilution?
Dilution occurs when more shares are issued to the existing shares in a company. As a result, those existing shares translate to less ownership of the company. In other words, if you issue additional shares to employees or investors, you will be diluted. Providing investors ownership better aligns their incentives and rewards them for investing and assuming risk in your company. As a founder, being diluted and owning less of your company can actually net you a higher return as your company utilizes the additional capital to grow faster.
tl;dr You can't issues new shares to others without giving up a part of your company.
What is an employee option pool?
When new employees join a company, they may receive stock options. Options give them the right to buy a certain amount of stock at a certain price within a certain time frame. Stock options typically vest over time, so that the longer an employee is with the company, the more options they earn. This helps align incentives between employees and the company by providing them with the ability to benefit from increases in the company’s value. Typically, 10-20% of company stock is set aside for incentivizing new employees.
tl;dr An employee pool sets aside stock that is used to incentive new employees.
What is vesting?
Vesting awards stock and options over time to prevent founders and employees from just walking away with shares of the company. It’s common to vest 25% of shares after the first year, with nothing vested within that year. This provision, known as a one year cliff, closely aligns employees’ interests with the company’s. Provisions can also reward employees in favorable situations, such as accelerating vesting schedules if the company is sold, or prevent rewarding early departures in termination scenarios when an employee is fired.
tl;dr Vesting makes sure people have to earn their ownership in a company.
What is a cap table?
A capitalization table, or cap table for short, lists all the major shareholders in your company. There isn’t a set format for how to lay out your cap table. In general, for each shareholder, it can include the number of shares owned, type of shares owned, and percentage ownership in the company. A cap table can be used to determine how the ownership of individual shareholders change with each new round of funding. It can also be used to show how changes in the employee option pool changes shareholders’ ownership.
tl;dr A cap table breaks down the ownership and rights of stockholders in your company.
What is a board of directors?
The board of directors has the power to make high-level management decisions for the company. At an early stage company, the board is typically comprised of the founders and, sometimes, an investor with the most skin in the game. Though ownership can be indicative of who is on the board of a startup, it does not automatically translate into a board seat. Investors do not automatically become board members. The size of the board and who occupies seats are determined by the current board in fundraising negotiations.
tl;dr The board of directors has voting rights on high level management decisions.
How do I protect my code, ideas, and other intellectual property?
An invention assignment makes sure the company owns any work produced on behalf of your company, not the individuals who did the work. This protects the company from an employee, even a co-founder, who may want to take work to another company or perhaps start a competitor. The strictness of the invention assignment can vary in scope. Some can broadly encompass all work produced by employee regardless of where it was produced, while others relate only to specific situations or types of work.
tl;dr Use invention assignments so that the company owns the work being produced.