Monday, January 31, 2011

The "Nitty Gritty" of Startup Formation

Part 1 in a series in Startup Stages

I'm often asked by first time entrepreneurs what's involved with setting up a business.  Do I need to incorporate?  What do I need to know about hiring?  Payroll?  Do I need a CPA?  How do I register my business?  Why do I need to bother with any of this at all?

The fact of the matter is that for most entrepreneurs non-core activities like filing DE-1 forms and negotiating insurance rates are at best a necessary distraction to the value added tasks of creating product, finding customers, and building a team.  At worst, they can be a confusing labyrinth of rules, regulations, and risks which if ignored or mismanaged can hurt your business.  Unfortunately, business does involve some non-core, administrative overhead that cannot be ignored.  And what you don’t know can bite you.

Compliance with regulatory requirements and contractual terms is a risk-mitigation matter that must be properly managed. While entrepreneurs are often comfortable managing technical and business development risk, they are often less comfortable at managing the legal, financial, and insurance risks.

Poor execution in these areas can hurt a startup’s chance of success in several ways:
  • Subject the startup to legal sanctions or other penalties
  • Unnecessarily increase overhead cash burn, the lifeblood of a startup
  • Jeopardize intellectual property rights
  • Impair the startup’s ability to obtain downstream funding
  • Cut into an entrepreneur’s most precious resource: TIME!
Large companies can afford the legal, accounting, and other risk management specialists to the degree required (i.e. $$$) to ensure compliance and minimize other risks. But unless you’re a lawyer or CPA or you have an exceptional amount of startup capital, it is unlikely that you’ll be able to do the same.

However with some upfront planning and an understanding of what to look for, it is possible to ensure regulatory compliance and mitigate the largest risks while minimizing cash burn and the impact on your time.

Understanding Risk/Cost Tradeoffs
Using the example of a prototypical technology-based startup in California with eventual plans to seek institutional funding, let's trace its evolution to show how compliance and risk management requirements increase as the business grows.

For most startups, the burden of compliance and risk management increases when the business begins undertaking specific activities that trigger new levels of risk.  The main risk triggers are:
  • Formal Organization, “Friends & Family” Funding, and Issuance of Founders’ Shares
  • Intellectual Property Creation
  • Purchasing by the Business of Products and Services from Third Parties
  • Hiring Employees
  • Leasing Space
  • Accepting Customer Purchase Orders
Let's start by looking at the very first stage leading up to formal organization.

In the beginning....
Prior to the creation and registration of a formal business entity the founding team is informally affiliated, with each person contributing time and money on a voluntary basis and with each individual responsible for his or her own expenses. At some point, as the startup begins to gain momentum and both time and expenses mount, there is usually a desire for the founding team to organize formally so as to limit the founders’ liability to third parties. The founders may also be raising seed capital from “friends and family,” most of whom will be passive investors unfamiliar with the day-to-day activities of the startup.

Formal Organization and Issuance of Founders’ Shares
Corporations and limited liability companies are artificial constructs which serve to limit shareholder and employee liability to third parties. To achieve this, one must comply with the governing laws. In addition to limiting liability, formal organization as a corporation or an LLC defines the following:
  • How the economic benefits and risks are to be shared amongst the founders and investors (i.e. shares, share classes)
  • How those benefits will be taxed
  • The rights and responsibilities of the parties involved
  • The compliance requirements to keep the entity in good standing
For startups, the most common business entities chosen are:
  • Limited Liability Company (“LLC”)
  • IRS Sub-chapter C Corporation (“C-Corp”)
  • IRS Sub-chapter S Corporation (“S-Corp”)
The decision as to which business entity to select will have the following implications:
  • Tax treatment
  • Eligibility for financing from institutional investors
  • Administrative burden(least for an LLC, greatest for a C-Corp)
There are tradeoffs associated with the above that need to be considered. While there are a number of “do-it-yourself” books available to help you select and register the proper entity, an attorney is usually the most cost effective way to ensure this is done correctly.

At this stage, assuming there are no employees, compliance requirements are low and involve just a few items:
  • Filing Articles of Incorporation or Articles of Organization with Secretary of State
  • Board adoption of Bylaws and organizational resolutions (in the case of a corporation) or execution of Operating Agreement (in the case of an LLC)
  • Issuance of shares to founders in compliance with Federal and state securities laws
  • Securing of a Federal Employer Identification Number (“FEIN”) from the Internal Revenue Service
  • Filing a fictitious name statement if the business will be conducted under a name different from the name stated in the Articles of Incorporation or Articles of Organization
Even if there are no employees, an FEIN is usually required by registering agencies and frequently needed for setting up bank and supplier accounts.

Commensurately, ongoing administrative overhead is low, involving:
  • Filing annual Statements of Information with the state
  • Filing annual Federal and state tax returns
  • Basic accounting and record keeping throughout the year adequate to support the tax filings
  • Execution of annual written consents reflecting actions of the shareholders and Board, including election of Board members and appointment of officers
  • Periodic updating of minute book share registry to reflect stock or option grants
It is advisable to keep the share registry updated, especially as the startup approaches the professional funding stage. There is nothing more frustrating than preparing to close a multimillion dollar funding deal and not being able to get cousin Bobby’s signature because he’s moved to Timbuktu, address unknown.

At some point, the startup may raise funds from “friends and family” or angel investors. As part of the financing process, it will have to make certain representations regarding financial and legal matters. So compliance with these matters will greatly facilitate the financing process, while compliance gaps will complicate it.

Next post:  Implications of Intellectual Property Creation

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