Dealing with the Nitty Gritty: Resources and Wrap Up

Part 6 and final post in a series in Startup Stages

Co-founders.  Suppliers.  Employees.  Customers.  Government.  So what are the compliance and risk management resources available to a startup?

• Do-It-Yourself Resources – There are a host of websites, guides, and other resources supplying legal templates, HR compliance kits, on-line payroll management etc. While inexpensive in terms of dollars, this route can be very time consuming, requiring the entrepreneur to learn about, select, integrate, implement, and manage all of the separate pieces.
• Attorneys, CPAs, and Other Professional Outsource Firms – Legal, accounting, HR, and other compliance professionals can be hired on an outsourced basis, greatly simplifying the management burden on the entrepreneur and increasing the quality of compliance and risk management. But these professionals are very expensive, need to be actively managed, and in the end, you the entrepreneur will need to integrate it all together. In addition, these professionals are advisors, not operating people, and are often more risk averse than the entrepreneur needs them to be, resulting in unnecessary expense.
• CFOs, CAOs, HR In-house Staff – Of course, you can hire your own CFO, CAO, or HR staff who will be able to take care of many of these issues directly, thus minimizing the use of the more expensive professionals.  They can also manage the professionals when more complicated issues arise, reducing the time burden on the entrepreneur. But it may be the case that you don’t need these positions staffed on a full-time basis, in which case hiring internal staff may not be the most cost effective solution.

In Summary…
While the startup must manage a number of compliance and risk issues, the main ones are liability protection, tax compliance, and employment law compliance. In terms of summary practical guidelines, the startup should:

1. Organize formally early to put in place basic liability protection and establish the most favorable tax treatment for the business.
2. Define intellectual property strategy and processes early in order to maximize the value of the startup’s intellectual property and minimize the risk of infringement.
3. Do the appropriate trademark searches, and register your domain names and trademarks early on, to minimize the risk of having to change your name after brand equity has been built up.
4. Be aware that hiring employees is a significant step up in legal compliance requirements and insurance overhead that the startup will need to bear and should have the processes in place to handle beforehand.
5. Delay leasing dedicated space, with its attendant addition of long term liability and insurance overhead, as long as possible. Consider hosted office space as an alternative.
6. Be aware that customer contracts will introduce an additional step up in potential liability and insurance overhead. The startup should have the processes in place to handle this before accepting a contract.
7. Select the appropriate resource/cost for the level and complexity of risk.  Do-it-Yourself resources are fine for simple, more mechanical processes, while ill-defined or complex issues, like intellectual property strategy, should be handled by the appropriate specialists.

Related posts in this series:
The "Nitty Gritty" of Startup Formation
Intellectual Property Creation and Startups
Startup Stage:  Buying Stuff and Independent Contractors
The BIG Risk Trigger:  Hiring
Space (and) The Final Frontier

Space (and) The Final Frontier

Part 5 in a series in Startup Stages

In this post, we deal with the last two pre-institutional funding risk triggers.

Leasing Space
One mistake startups make is leasing dedicated space too soon. In some cases this is unavoidable (e.g. if you are a manufacturing company handling hazardous materials or requiring heavy equipment). But for software, Internet, or light hardware development, there may be more cost effective options.

Leasing can add considerably to the cash burn, administrative overhead, and risk of a startup. While the NNN lease rate may be low, required insurances, taxes, utilities, common area expenses, and maintenance can easily double the rate. In addition, landlords often require multi-year (3-5) agreements with security deposits, tying up or committing limited cash.

On top of this, there are upfront costs associated with tenant improvements, furnishing, and permits.

New compliance issues include:

• Local fire department regulations/ inspections
• Insurance policies: property and liability ($1-3 million policy coverage required by most landlords)
• Worker health and safety including evacuation plans, notice postings
• Special operating permits depending on the nature of the business (e.g. environmental, hazardous materials)

Additional overhead:

• Utilities (electric, gas, water, janitorial, alarm service)
• Facility maintenance and repair (don’t assume the landlord covers it)
• Facility safety

Really think through whether you need to lease space. While employees create value, furniture does not.  If you must lease space, take a look at which employees really need to be physically co-located and which do not. (It’s amazing how space efficient a person with a laptop, Wi-Fi and a cell phone can be.)

As an alternative, consider hosted office space (also called executive offices). While at first glance, base lease rates are more expensive than dedicated space, total operating costs may actually be cheaper. Hosted offices usually come fully furnished with utilities, are available on one year or shorter leases, don’t require insurance, and have a range of amenities including kitchens, meeting rooms rentable by the hour, office equipment charged on a per use basis, and reception desk services.  Just watch the notice period requirements for cancellation; they can be as long as three months!

The Final Frontier:  Accepting Customer Purchase Orders
Congratulations! You're no longer pre-revenue; you’ve closed your first sale! The P.O. or contract just hit your email… and with it a new set of legal obligations.

A purchase order is a legally binding contract and by its acceptance, the startup is obligated to perform in accordance with the terms and conditions negotiated. In addition to price and delivery, terms to be negotiated should include:

• Product or service acceptance criteria (specifications to be complied with or other conditions that allow closing of the contract and subsequent invoicing)
• Warranty terms, indemnities, and other liabilities
• Damage exclusions
• Title risk transfer
• Payment terms

In order to avoid reinventing the wheel for each contract, the startup should have its own standard sales T’s and C’s covering these. If the startup doesn’t furnish its own T’s and C’s, it could inadvertently end up agreeing to the customer’s T’s and C’s.

Assuming the startup has the associated operational infrastructure for sales order processing, development, production, quality control, and shipping, the additional administrative overhead required includes:

• Sales terms and conditions
• Accounts receivable, invoicing, and collections
• Insurance policies: product liability and/or errors & omissions (services)

If the startup uses distributors or sales representatives, it will also need the appropriate agreements defining the commercial relationship.

Next and final post in the series:  Dealing With It

The BIG Risk Trigger: Hiring

Part 4 in a series in Startup Stages

The hiring of employees is probably the most significant compliance and risk trigger for a startup, (especially in the State of California). This includes the case where the founders are placing themselves on the payroll as employees, rather than compensating themselves as partners. Beyond the risk issue, to attract and retain employees, the startup may need to offer benefits and stock incentives, each of which has its own set of compliance issues.

Knowing this, some startups try to minimize their employer obligations by treating everyone as independent contractors. Unfortunately, Federal and state laws restrict the degree to which this can be done and businesses that run afoul of these guidelines can find themselves owing serious back taxes, benefits, and penalties.  (See my prior post on this subject.)

Compliance requirements now include:

• State of California EDD (or equivalent) Filings:  DE-1, DE-34, and Employer Account Number
• Federal and state laws governing wages and hours, discrimination, and wrongful termination
• Federal and state withholdings for various payroll taxes
• Worker’s compensation insurance coverage (mandatory in California, different by state)
• Benefits provider rules
• Federal and state securities laws with respect to stock options and/or restricted stock grants

(A detailed discussion of employment law compliance is beyond the scope of this blog post.)

The step up in administrative overhead can be quite significant. New policies and processes need to be put into place to ensure compliance, manage risk, and lower insurance costs. These include:

• Payroll and taxes
• Personnel management policies and procedures covering hiring, evaluation, retention, and termination
• “At Will” offer letters or employment contracts
• Worker health and safety
• Insurance policies: worker’s comp, employment practices, general liability
• Benefits administration
• Stock option/restricted stock grant program
• Intellectual property protection (see earlier post)

Of these, payroll and taxes can be readily outsourced, with a wide range of third party payroll processing services available. With respect to the art of managing a workforce, the best generic risk management advice is: think once, twice, thrice before hiring and do the reference & background checks! Believe it or not, there is one thing worse than not filling a critical vacancy and that is filling it with a problem employee.

Firing is not fun.

Next post:  Space!

Related posts in this series:
The "Nitty Gritty" of Startup Formation
Intellectual Property Creation and Startups
Startup Stage:  Buying Stuff and Independent Contractors

Startup Stage: Buying Stuff and Independent Contractors

Part 3 in a series in Startup Stages

So you think the purchasing of products and services from is straight forward?  While generally true of the former, the hiring of services, particularly that favorite of all startups, the independent contractor, can expose the startup to significant liability.  Let's take a look at the issues surrounding third party purchases by the startup.

Purchasing by the Business of Products and Services from Third Parties
Once a business entity exists, the founders need to shift the purchasing of supplies, equipment, and services from their personal accounts to the business, in order to take advantage of the limited liability benefit.  Keep in mind that goods and services paid for by the founders (i.e. via personal credit card) do not automatically belong to the business.  They must be transferred in.  The easiest way to do this is via some form of expense reimbursement policy.

Still assuming no employees at this stage, three additional compliance issues must be met:

• Ensuring that independent contractors (if any) are not de-facto employees under Federal or state work rules.  Just because your service provider is willing to be an independent contractor, does not necessarily make it so.  The government has a say in this.  (For more details, see my post.)
• For tax purposes, properly classifying inventory, depreciable assets, and expense items
• Obtaining a state resale certificate in order to avoid paying sales tax on items purchased for resale

In terms of risk management, overhead necessarily increases and involves:

• Executing independent contractor agreements with contractors
• Filing/issuance of IRS 1099-MISC and California EDD DE-542 forms or your state's equivalent (if independent contractors)
• Setting up a business checking account
• Creating accounting controls with respect to purchasing, expense reimbursement, and payables to reduce the risk of fraud and monitor cash burn
• Establishing purchasing terms & conditions
• Obtaining personal property and casualty insurance (if there is a high value to inventory or capital assets)
• Protecting intellectual property (see last post)

For the hiring of services, a well written independent contractor agreement is key. At a minimum, it should (a) define contractor status, (b) assign to the business any intellectual property the contractor creates, (c) spell out contractor responsibility for withholding taxes and insurance, and (d) define the financial terms of the relationship.

Personal property insurance may not make sense unless the startup has expensive capital assets or a high value of inventory (both of which the startup should ideally avoid by outsourcing or building to order).The same goes for establishing purchasing terms and conditions (“T’s and C’s”), although unlike insurance, this costs almost nothing to set up. Having your own set of purchasing T’s and C’s will ensure that you are not inadvertently agreeing to the vendor’s T’s and C’s.

Next post:  The BIG Risk Trigger:  Hiring.

Related posts in this series:
The "Nitty Gritty" of Startup Formation
Intellectual Property Creation and Startups

Intellectual Property Creation and Startups

Part 2 in a series in Startup Stages

The underpinning of most technology based startups is the creation of intellectual property (“IP”) in the form of patents, trademarks, and trade secrets (including proprietary designs, software, process recipes, etc.). Yet surprisingly, many technology startups manage this poorly. Management must be diligent in avoiding IP risks, which include:

• Loss of IP rights through failure to obtain proper assignments
• Loss of IP rights through failure to adopt or enforce a lab notebook policy
• Disclosing too much proprietary information in provisional patent applications
• Loss of trade secret rights and foreign patent filing rights through disclosure of the startup’s secrets without an effective non-disclosure agreement
• Breach of non-disclosure obligations through disclosure of a third party’s trade secrets to outsiders
• Misappropriation of the trade secrets of others, especially prior employers
• Infringement of patents and trademarks owned by others
• Having to change the name of the company or its products after brand equity has been built up, due to trademark infringement

The administrative overhead required to manage these risks include:

• Non-disclosure and invention assignment agreements and the associated business processes for their execution and tracking
• Business process for the keeping of lab notebooks, mining of patentable inventions, review of invention disclosures, and filing and prosecution of patent applications
• Employee education regarding the creation and protection of intellectual property
• Patent “clearance” searches prior to significant investment in new products
• Trademark searches to ensure that company and product names do not infringe the trademarks of others

Because trade secret law requires that the owner protect the confidentiality of its trade secrets, it is particularly important to have non-disclosure agreements in place before discussions with key vendors, independent contractors, and employees. In the case of vendors and contractors doing custom work, those vendors and contractors should execute, in advance, agreements assigning to the company any IP they create in connection with their engagement. Don’t assume that because you paid an engineering design firm to do contract work for you that you own it; you’d be surprised what the fine print might say.

A Cautionary Note About NDAs
Did you know that signing a mutual non-disclosure agreement can potentially:

• Impair your ability to commercialize your own inventions?
• If used indiscriminately, impair your ability to claim trade secret status for your legitimate trade secrets?

To minimize this risk, be selective with whom you sign NDA’s and use one-way non-disclosure agreements where possible.  For more about the ins, the outs, and the limitations of NDAs, see my post on What Every Entrepreneur Should Know About NDAs.

So what's the best way to deal with these issues?  If intellectual property is an important element of your startup, hire a good lawyer.  This is not the place to pinch pennies nor does it necessarily mean using one of the big law firms.  Look for an intelletual property lawyer with domain expertise in your technology area.

At this stage of the startup’s life, the compliance and risk management issues are relatively straightforward to manage. However, these escalate significantly in terms of complexity and downside risk as the business begins to issue contracts and hire people.

Next post:  Purchasing Goods, Services, and the Thorny Issue of Independent Contractors.

Related posts in this series:
The "Nitty Gritty" of Startup Formation 

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

Independent Contractors, Uncle Sam Wants You!

For many reasons, early stage startups love to hire contractors instead of employees.  Independent contractors are often cheaper, the company doesn't have to pay employment taxes, benefits, or worker's compensation insurance, HR compliance issues are simpler, and the company retains workforce flexibility.

Unfortunately, I have to remind my clients that the choice as to whether someone is an independent contractor or an employee is not necessarily up to them.

"But we're only going to hire them a few hours a week!"  Sorry, but full time vs. part time does not determine whether someone is a contractor.  They might be a part-time employee.

"But they want/have agreed to be an independent contractor!"  Sorry but willingness on the part of both parties is not a determinant either.

So who does determine whether someone is an independent contractor if not the two parties involved?  The IRS and the state.

Why?  Because the U.S. government really wants as many people as possible to be classified as employees. The reason? Take a look at this graph:

Notice that between individual income tax and payroll taxes, 81% of government income comes from employee based revenues.  Now independent contractors also pay income taxes and will pay their equivalent of payroll taxes (1040 Schedule SE) as self-employment tax.  But the amount will generally be less because of one key difference: employees earn a wage that is taxed after which expenses are paid. Self-employed individuals, on the other hand, are small businesses which earn revenue, deduct business expenses, and only then pay taxes on the net, which is most often a smaller number.  This means less taxes to the government.  (It's also one reason why only 12% of government income comes from corporate income tax.)

So what determine whether a person is an independent contractor vs. an employee?  Unfortunately, the answer is not clear cut.

The guidelines used by the U.S. Dept. of Labor, IRS, and (in California) the Employment Development Department (EDD) is whether the employer has the "right to control" a person's work whether it is exercised or not. They also look at whether the contractor can suffer the risk of loss, provides their own tools, have their own workspace, are publicly available for business with multiple clients, and the duration of the work engagement.

So how do government auditors determine this?  Largely its a judgment call.  With respect to the above factors, the more often the contractor answers "no" and if the engagement extends more than six months, the more likely the auditor is going to want to classify that person as an employee.

The IRS used to have what it was called a twenty point test, but replaced this a few years back with the more ambiguous guidelines in effect today.  Note that the penalties for misclassifying someone who should be an employee as an independent contractor can be significant including back employment taxes, associated interest, and penalties.

"So how will anyone find out?"  It usually happens when someone unfamiliar with the laws and working as an independent contractor gets terminated and files for unemployment benefits, listing the company as the last employer.  But independent contractors are not eligible for unemployment benefits; they are supposed to be independent businesses.  This can then trigger an audit.  And in the current economy with many state governments running budget deficits and the widespread abuses in this area, state auditors are getting much more aggressive about going after small businesses, which are much more likely to be in violation.

So what should a small business or startup do to protect themselves?

1. Signed Independent Contractor Agreement - You should have a signed agreement drafted by an attorney.  It should spell out that the contractor is responsible for filing and withholding their own taxes and have their own insurance (general liability, workman's comp if applicable).  It should also have a statement of work that preferably outlines a work project with milestones, deliverables, and project fee vs. just calling out a rate and general duties.
2. Determine what control is necessary over the way the work is performed - While you have the right to determine what the work product standards and deliverables should be, the more the contractor determines how, where, and when the work gets done, the more likely the contractor will be considered independent.  If a job requires that the person follow your detailed policies and procedures, under your supervision, at your premises, using your equipment, you probably need to hire an employee.
3. Review the IRS guidelines mentioned above -  See how many of these factors your contractor can pass.  The more the better.
4. Check to see if the job falls into the "statutory" category - There are certain jobs that have been defined by law to be employees.  Examples can include officers of corporations, full-time dedicated sales people and insurance agents, agent/drivers in food service, laundry, or dry cleaning, or home workers performing work on employer supplied materials.  The list can differ from state to state. 

If in doubt, consult a human resources specialist or labor attorney for advice.  The hour fee is worth it.  Or if you don't want to do that, all you have to do is file a Form SS-8 with the IRS.  They'll be happy to provide their objective, unbiased opinion.

What Every Entrepreneur Should Know About NDAs

Warning:  This post contains self-promotional material

When I'm not doing marketing consulting, I'm co-founder of a company that provides integrated general & administrative services for early stage startups and other small businesses.  Many of our clients are technology based and one area where we get a lot of questions centers around non-disclosure agreements ("NDAs").  How effective are they?  When should I use them?  What are the pitfalls?

Recently, my co-founder at Infrastructure Group, John Horn, who also has a law practice serving Infrastructure Group clients and other technology companies, started his own blog, Law for Entrepreneurs as a service to our clients and others who may be interested in the legal issues faced by startups.  His advice comes from years of practice as a corporate general counsel (i.e. an operating guy) vs. from years of practice at a big law firm (i.e. the billable hours folks...tick, tick, tick....)

John has just completed a three part "tutorial" on NDAs that I highly recommend:

What an NDA Is (and is Not) Good For

Consider the Context Before Asking for an NDA

When Someone Asks You to Sign Their NDA

(Incidentally, having dealt with many, many NDAs over the years, given the similarity in provisions, I'm convinced that they are all spawned from one template that's been circulating around Silicon Valley since the 1960s.  Something to think about the next time your attorney offers to review an NDA for you for $400!)

Happy reading and don't forget to subscribe!