Often people start a company without any clear idea of what
a company is. Entrepreneurs closet themselves in the garage and start writing code.
While the modern tech world could not exist without obsession, artistic inspiration and crazy engineers,
there’s more to a startup than passion.
In this post, we explore the basics
behind corporate entities, stock, financing, and the key non-technical infrastructure
To make an idea really powerful, a startup needs
to become a real company. In former days, this might have meant bureaucracy, and
lots of financial and legal infrastructure. Today’s
tech companies are simpler, but still require a set of rules, and you need a rudimentary
understanding of business law when forming a corporation.
There are several ways of conducting business in
the United States. The most basic is a
which is essentially self-employment. A sole proprietor, such as a grocery store or
restaurant, assumes full legal liability for the
business, but all income is direct personal income
and is taxed once.
Another form of business is a Partnership. This is a venture between several
individuals who share in the profits. Partnerships, and particularly Limited Liability Partnerships (LLP),
are created to address the personal liability issue with proprietorship. With LLP only one or a couple
of partners assumes the legal liability.
Corporations are a separate legal entity. When a corporation is sued, in
general the individuals
behind it (shareholders, directors, management) are not impacted. This legal protection
comes at a price – double taxation. Companies have to pay tax and only then can pay salaries and dividends to the shareholders.
In recent years, people have been incorporating in two principal ways – LLC and Inc. LLC is a limited liability corporation,
a hybrid between corporation and a partnership.
LLC enjoys the legal status of a corporation, but has partnership-like taxation. It is a great way to incorporate before you know how big your company
will become. The caveat
with LLC is that you can’t have more than a certain number of shareholders (typically around 70). For this reason, Venture Capitalists
would normally not fund an LLC because it’s impossible to take such a company through an IPO (Initial Public Offering).
Most tech startups end up being C-Corp or a corporation
you can start with LLC, then convert to a C-Corp right before raising substantial funding). A corporation
is the most sophisticated business entity. It is a powerful but complex vehicle,
Shareholders, Directors and Management
A company starts with incorporation – a process of forming. These days
it’s cheap (around $300) and straightforward.
You can either incorporate on your own or, better, utilise your accountant or lawyer.
You incorporate in a particular state, usually Delaware with its liberal laws and taxation policies.
You don’t need to live in Delaware to incorporate there, but you do need to also declare your existence to whatever state(s)
you plan to operate in. The corporate laws vary substantially, so ask your lawyer and
accountant about regulations in your state.
After incorporation, you issue a stock – a unit of ownership in the company. In startups before funding,
there is little reason to spend time on issuing shares, because when financing
comes you’ll need to reissue.
Easiest is to declare that you have 100 shares of common stock and divide it between the founders as
agreed prior to
starting a company.
There are three principal types of participants in every company – shareholders,
directors and management. Shareholders,
or the owners, vote and elect the board of directors, who set long-term strategic direction
and appoint executive management. The management (CEO, CTO, etc) is responsible for the day-to-day operation of the company.
While you might find this 3-tier structure initially confusing, it does make sense.
In large companies directors are mostly
outsiders. Directors represent the interest of shareholders and hold management accountable for the performance
of the company. In a large corporation, typically the CEO is also a President or Chairman of the board, but the rest
are directors outside the company. For small startups, the situation is simpler.
You are a shareholder, a director and a manager of your own company.
In a startup, you need to understand when to wear
the hat of a shareholder, director or a manager. Looking at a company from the perspective
of key legal documents helps you do that.
The first document is Articles of Incorporation,
which declares the kind of entity, state of operation, classes of stock, and number of shares.
The next is a Shareholders
Agreement, which typically discusses the rights and obligations shareholders have in
situations like sale of the company, sale of stock, or death of a shareholder.
And Corporate Bylaws is the guide by which
the board operates;
it specifies who can be a director, how often meetings are held, how voting is
The employees of the company – e.g. CEO, VP of Design and Software Engineers – all sign
These days, employment agreements typically consist of a short offer letter and a lengthy non-competition agreement.
The letter outlines the position, salary, vacation, and other benefits. The letter
asks the employee
to obey standard corporate rules and regulations. In addition, a lot of startups offer employees stock options – a way
to earn the right to buy a stock in a company.
Legal and Finance
A first-time entrepreneur will find the
legal complexity and accounting for a corporation overwhelming.
It is essential to hire lawyers and financial professionals. There is a saying amoung startups
and VCs that a good lawyer pays for him or herself, despite the fact that hourly fees are
There are three kinds
of lawyers needed in a tech startup. A corporate lawyer drafts the basic documents and
will advise on daily matters. A deal lawyer specializes in financing and sales transactions.
if you have intellectual property to protect, then you’ll need an IP lawyer.
Financials of a startup can be split into daily simple things and annual complex
For a startup, it is ideal to get a bookkeeper – a person to take care of payroll, monthly profit and loss,
and basic financial documents. You need an accounting firm for annual taxes and larger issues.
are more expensive than bookkeepers, but since you don’t need to use them for daily operations, it makes
sense to have an accounting firm do your annual finances. In addition to taxes
will product a compilation – a summary of annual activities. After you get funding, the board of directors
will ask for an audited financial statement – a full, certified financial review.
To turn your idea into a big company, you will likely need to raise money.
This is essentially a sale of
shares to investors. A typical company goes through several financings – angel investment and then
a few rounds of venture capital. The angel round is typically small, traditionally less than a million dollars
and lately substantially less (thanks to YCombinator and TechStars).
In the angel (or seed) round, the founders may offer 10-15% of the company in exchange for a convertible loan.
Technically, this is not a direct sale of shares, but instead a right to buy shares in the next round of financing
at a discount, while accruing interest.
Traditional angels are wealthy individuals, often former successful
enterpreneurs and executives at
large companies. Each angel might be willing to put down between 10-100K, with 25-50K being typical.
So if looking to raise 500K, you would need to line up 10 or more angel investors. You can simplify
it if you find a local group, for example New York Angels.
The next round of funding, called Series A, involves Venture Capitalists (VC). A venture firm is essentially
a partnership that manages an investment fund. The fund raises money and invests
into startups and later stage companies.
The VC world is complex and it’s important to know how to navigate it.
The first rule – know what firms are right for you at what stage. The right firm will be the one that’s interested in the sector you’re in
as well as the size of the investment. VC firms manage anywhere between $150M – $1B, with
tech fund being around $300M. Since the time of each partner in the firm is limited, there
are only so many investments the fund can make. So, if looking for 500K, it doesn’t make sense to approach VCs.
A typical Venture Firm will look to own 20 – 30% of your company over its
lifetime. When the investors put money into your company, they will protect themselves in cases when the company
might not do well. They will ask to create a class of preferred shares (preferred stock) that will
be subject to different rules than the common stock (those you own). Preferred stock is paid first
in case of an exit, and it enjoys veto rights such as precluding you to sell the company, or the
opposite – forcing a sale.
It is common for a venture firm to elect a director on your board.
This is the partner you are essentially working with. In early stage companies,
a VC plays an instrumental role in mentoring the CEO and shaping the course of the
company. As the company grows and perhaps even goes public, the VC director steps down from the board.
Each round of funding expands the number of Venture firms at the table and results in
To understand dilution, one needs to understand the mechanism by which startups raise money. Each round of
results in additional shares being issued by the company and sold to the investors.
Typically, investors are not buying
shares that you already have, they are buying newly issued shares.
The money raised is not going into
your pocket, it goes to the company. In some cases, when you’re doing stellar, investors would be
buy your shares – but this is atypical. As a result of each raise, founders and employees own less percentage of the company
(their number of shares remains the same, but the total number of shares increases). Prior investors are able to
maintain their respective ownership by buying additional shares (this right is given
via preferred stock).
Despite the fact that startups are reluctant to give up ownership to VCs, the economics actually make sense.
Even though your percentage of ownership goes down, the total value of the stock is higher after the financing, because
the value of each share rises. As long as the company is doing well, fund-raising makes sense and is beneficial to its employees.
There is a considerable amount of complexity surrounding building a company. Way more than just
a great idea
and elegant code is involved. But building a company, learning the intricacies, understanding the law and venture
world, is fun.
Instead of being afraid of this complexity, startups need to appreciate it and embrace it.
Most lawyers, accountants and investors are smart people whom you will
learn from. They will help you make your startup into a real company.
As a start point, you should create an LLC and not worry about much paperwork. Once you
get into investment, you’ll need to change to an Inc, get a lawyer, bookkeeper and accountant, and start diving
into the details discussed in this post.
As always we look forward to your questions and we also ask you to share your tips on the essentials
you picked up during your startup life. Join the conversation!