Google, Mattel, Disney are all successful companies which started in someone’s garage. But, according to the US Bureau of Labor Statistics (BOL), within 10 years, 2/3 of all Startups are out of business. If you also add in the failures which never reach BOL’s radar, the percentage will approach the oft quoted 96% failure risk. It is rough out there.
The largest business risk is the failure of the product or service offering and/or poor market timing. However, weak corporate fundamentals will also kill a Startup. This article discusses some of these corporate fundamentals – Legal Structure and Funding.
Business Entities – Protected Yourself: Incorporate
Murphy’s Law didn’t develop out of thin air: if anything can go wrong, it will. Prudent entrepreneurs protect their personal assets through incorporation. The most common options are:
- Sole proprietorship or do nothing at all. Essentially, a sole proprietorship is self-employment where the grocery store owner or tech start up assumes full legal liability for everything. From a liability point of view, this approach is high risk and is therefore NOT recommended any more than running naked through a park at night is.
- Partnership. This form of business entity is an agreement between several individuals who share in the profits and losses. As a general rule, any income is taxed only once at the partner level. Since LLCs came onto the scene (see below), partnerships are less and less common.
- Corporation. Corporations, sometimes known as C-Corps, are separate legal entities with limited liability. Properly organized and operated, the most you can use is the money you put in; in this way, C-Corps are similar to owning any publicly traded stock. Unfortunately, this legal protection of limited liability comes at a price – double taxation. Companies have to pay tax on their profits and individuals have to pay a second layer of tax on any salaries and/or dividends they receive.
- Limited Liability Corporation (LLC). In recent years, LLCs have become more and more popular because they enjoy the legal protection of a corporation, but also only have one layer of tax like a partnership. It is a great way to incorporate before you know how big your company will become.
- S-Corp. An S-Corporation is a special type of corporation which, similar to an LLC, provides limited liability and a single layer of taxation. While immensely popular due to its taxation advantages over an LLC, they have more legal formalities and very specific rules on who can and cannot be a shareholder. For example, C-Corps and VC funds cannot invest in an S-Corp. Thus, if you are pretty sure you will be raising outside money, a S-Corp might not be for you.
As a practical matter, many Startups begin life as an LLC given its flexibility and simple structure, and then later on convert to a C-Corp when raising outside capital. Most VC funded companies and all public traded companies are C-Corp.
Rules and Regulation: State Law Requirements
Except for the sole proprietor, each entity type above starts with an agreement or incorporation document. While each entity type has its own unique rules and procedures, in many ways, they are very similar. For a C-Corp, it is relatively cheap (around $300-500) to incorporate. Since it is relatively straightforward, if you want, you can Do-It-Yourself. That said, for a few bucks more, it is wise to consult with a subject matter expert, like an attorney or accountant.
State laws govern the incorporation rules, so you will need to check. Fortunately, all states allow anyone to incorporate under their laws, residences and non-residences alike. With its liberal laws and taxation policies, Delaware is popular; Nevada and Wyoming are also growing in popularity. Regardless of where you incorporation, if you plan to do business in a state, you will need to register there. Since the rules can be tricky, especially with respect to online businesses, it is best to consult an expert.
The Golden Triad: Shareholders, Directors and Management
After incorporation, you issue stock, or a unit of company ownership. Before outside funding, there is little reason to spend time physically issuing shares – who cares since you will own all 100%? But, when partners or financing comes in, you will probably want to issue physical stock certificates. While not legally required (i.e., for example, have you ever actually held that Amazon stock you own?), it can provide assurance to partners and investors.
In a C-Corp, there are three principal types of participants: Shareholders, Directors and Management. Shareholders, or the owners, vote and elect the Board of Directors, who set long-term strategy and hire senior Management. Management (CEO, CFO, CTO, etc.) is responsible for the day-to-day operations.
In a small startup, this structure is unwieldy and unnecessary. You alone can be the sole shareholder, director and manager all rolled into one. But, as the company grows and gets more complex, roles will need to separate and specialize. In larger, publicly traded companies, Directors are usually outsiders, and represent the interest of Shareholders by holding Management accountable.
In any company, C-Corp, S-Corp or LLC, there are four key legal documents you need to understand:
- Articles of Incorporation. This initial document states kind of entity, classes of stock, number of shares, etc.
- Shareholders Agreement. This document is required only if two or more individuals or entities are part of the company. If it is wholly owned by a single person, a Shareholders’ Agreement is not required, but still advisable to have one. For example, if you already have a Shareholder’s Agreement, it will help in the negotiations with new, incoming shareholders to help them understand their rights and obligations in key events, like sale of the company, issuance of additional stock, or death of a shareholder.
- Corporate Bylaws. The Bylaws guide by Board of Director operations, for example, who can be a director, how often meetings are held, how voting is done, etc.
- Employment Agreements. Key employees (e.g., CEO, CFO, CTO) should all have an employment agreement. If there is anything worth protecting, like intellectual property or customers lists, then every employee should be similarly tied up. Employment agreements typically cover the position, salary, vacation and benefits, corporate rules and regulations, non-competition and non-solicitation periods, etc. These agreements can also provide stock options or warrants to early or key employees.
Outside Advisors #1: When Lawyers Are Actually Useful
A first-time entrepreneur might find the above legal rules and regulations complex and a bit overwhelming. Thus, it is good practice to hire a competent attorney and not just use Uncle Bob, a real estate lawyer, who will give you a “break on rates”. Among startups and VCs, a good lawyer more than pays for him or herself, despite the fact that hourly fees are whopping. Unfortunately, three different types of attorneys are needed:
- A corporate lawyer who drafts the basic documents and will advise on daily matters
- A deal lawyer who specializes in financing and sale of the company transactions
- An intellectual property lawyer if you have IP you need to protect
Outside Advisors #2: Watch Your Cashflow
Businesses run on cash. No cash, no business. From the start, a smart entrepreneur will understand the cash cycle and duration. At first, when activity level is low, a simple Excel spreadsheet or QuickBooks Online (or similar software) will suffice. Hopefully sooner rather than later, a financial professional will be needed. For daily clerical items, get a bookkeeper to handle payroll, monthly profit and loss, and basic financial documents. You need an accounting firm for annual taxes, audited financial statements, valuation opinions and so on.
Admittedly, accountants are more expensive than bookkeepers. However, like a good corporate attorney, they can be worth their weight in precious metals by reducing taxes, preparing VC worthy financial statements, and providing guidance on how to minimize fraud and embezzlement. For all the identity theft going on, the #1 fraud is still employees stealing and embezzling from their own company.
Venture Capital: Money, Money, Money
From a small idea to a big company, it takes money. Along the way, you may need to raise money by selling part of your company to investors. No one gets all the money they need first time around or right out of the gate. It is a multiple step process and may contain some or all of the following:
- Angel Investment. Angel investors are early investors and often are wealthy individuals such as successful entrepreneurs or former executives. As a general rule, Angel investors went to “give back”; in other words, do good and perhaps make money. Ranging from $ 10k to $ 100k per investment, most Angels will plunk down between $ 25k-50K. So if looking to raise $ 500K, you would need to line up 10 or more Angels or an Angel group.Landing the first Angel is a nightmare, but the 2nd through nth is much easier because you have been vetted by #1. Yes, Angels flock together.
In exchange for convertible debt (e.g., debt which can be converted into stock at a discount later in the future), you will give up 10-15% of the company to Angel investors.
- Crowdfunding is an alternative form of Angel investors. Crowdfunding sites have popped up around the internet. See YCombinator, TechStars, Indiegogo and Kickstarter. As an emerging equity source, the rules are still in flux: the Security and Exchange Commission has issued rules, but not the IRS. Be careful, but opportunistic here.
- Series A. Eventually you may need to involve Venture Capitalists (VC) or investment fund, which invests in later stage companies. The VC world is extremely complex and competitive. In contrast to Angel investors, VC want to make money first, perhaps do good second, and will generally take double what an Angel would, typically 20 – 30% of the company. Using preferred stock (as opposed to your common stock), VC will have certain preferences or privileges that other more common shareholders do not, such as a board seat and governance clauses permitting the VC to hire/fire executives (including you) and/or sell the company. Preferred stock is paid first; you last.
- Series B, C, Etc. Each additional round of funding expands the number of VCs at the table and results in dilution. You are not selling them your shares, but issuing new shares and the cash goes into the company and not into your pocket. After 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). But, it can still be a win-win situation – you will have a smaller overall percentage of a much, much large pie especially when the Startup, now a company, is doing well and making profits.
After the idea has germinated, there is a considerable amount of legal and financial complexity in order to build a successful company. It is way more than just a great idea and hard work.
That said, at the beginning, go easy — create an LLC and don’t worry about engaging an expensive army of outside advisors. Once things get going and/or money is being raised, get a good lawyer, bookkeeper and accountant, and start during your homework.
Instead of being afraid of this complexity, you need to appreciate and embrace it. If fact, successful entrepreneurs study this area as much or more than their own business ideas and are willing to learn from their lawyers, accountants and investors. At the end of the day, everyone’s incentives are somewhat aligned – to help you make your Startup into a real company because in that way, everyone earns a nice return.
Brett R. Keenan is a CFO/General Counsel for Small Businesses, Business and Executive Coach, and author of “Small Business 101: From Start-up to Success”. Based in Chicago IL, BRKeenan & Associates has helped numerous large and small companies succeed, focusing on Finance, Law, Strategy and Operations since 1999.
©BRKeenan & Associates, LLC. October 2015