HOW TO START A STARTUP PART 1 OF 2
So how the hell is everyone doing this? How are people creating a startup?
I tell you in this article. FIRST--you need to understand the background and guiding principles of how to create a startup. If you don't care to understand the fundamentals and the essence of the matter, this site is not for you.
As a corporate lawyer/startup lawyer, I make sure that EVERY ONE of my clients understands at a basic level what is going on. I'm not talking about the really painful tedious details--that's my job. I'm talking about the essence of the matter. A more informed entrepreneur is better for their own company and at the end of the day is better for himself/herself.
I explain in this article the background and guiding principles of how to create a startup. Part 2 details how to apply these principles and actually technically do it.
Summary of How to Start a Startup Part 1 of 2
1. The technical details of the very start of a startup is confusing to entrepreneurs.
2. Prior and concurrent to starting--founders need to get their employment matters sorted; define the roles of the individuals in the company; as well as protect themselves from each other, from the outside world, and from future investors.
3. Founders will create the company and authorize stock. The company will then issue common stock to the founders. This is just regular common stock and is the same type of stock future employees and personnel will receive. Preferred stock gets issued to investors. Don't worry about preferred for now.
4. The stock that founders receive must be paid for. This payment is in the form of cash, IP, and/or services. Founders will sign an agreement that details the terms of this purchase.
5. Founder's stock needs to be subject to a vesting schedule. This will make sure that founders have to stay with the company for a certain amount of years in order for the stock to truly be their own stock. This gives incentive for individuals to stick to the matter at hand.
Explanation of How to Start a Startup Part 1 of 2
Table of Contents
Part 1 of 2. Background and Guiding Principles
A. Get your employment matters sorted
B. Define the startup roles properly
C. Decide how much company equity each person should receive
D. Protect yourself from your startup co-founders
1. Go into business only with people you trust
2. Vest Shares
3. Anticipate business problems before they arise
4. Have well drafted bylaws and agreements of the company
5. Have share transfer restrictions
6. Assign IP to the company
E. Protect Yourself from the outside world
1. Don't do business with shady people
2. Use proper documentation and have contracts properly drawn up
3. Work with government agencies
4. Have your books and corporate documentation properly set up
F. Protect yourself from investors
1. Understanding Dilution
2. Type of stock
3. Other Ways to Protect Your Startup
Part 1 of 2. BACKGROUND AND GUIDING PRINCIPLES OF HOW TO START A STARTUP
Founders are often confused as to how to technically get the startup ship out of the dock. Yes, they know about certain issues to avoid or to be conscious of down the road, but they are confused as to how to just START.
This article addresses these and other questions: how do the first shares of the company get dished out? How do founders get their shares? What kind of shares do they get? How many shares? What price?
First understand and do the following:
A. GET YOUR EMPLOYMENT MATTERS SORTED
Elsewhere, I have already told you how you should protect your startup from employers. If you read this bit here and feel like this may be a significant roadblock in your starting a company, read that article to figure out how to navigate the issue.
However, even if it's not an issue for you, here's an important point to keep in mind: don't let your co-founder's bullshit become your bullshit.
Even if you don't have an issue with employers that doesn't mean that your startup is in the clear. It's your job to also make sure that your co-founders do not have employment issues that can disrupt the startup. You need to:
a. Make sure that IP belongs to the startup and not to your current employer, not to your previous employer, not to your CO-FOUNDER'S current employer, and not to your CO-FOUNDER'S previous employer.
b. Make sure that non-competes and other contractual issues with current employers do not interfere with you creating a startup. Again, just as importantly--make sure the same is true for your co-founder.
c. Make sure that contractual issues with previous employers don't interfere either.
STARTING A STARTUP IN TEXAS
As I mentioned before, some of the matters concerning employment issues depend on state law. Non-competes, and confidentiality agreements have different potency depending on where you're creating a startup. When starting a startup in Texas (or any state really) pay attention to state employment law. Texas law scopes what can and cannot be in some of these agreements. A lawyer can help you analyze this.
B. DEFINE THE STARTUP ROLES PROPERLY
Recently I spoke to two entrepreneurs in the energy tech industry. They had a successful startup going but it was on the brink of collapse.
The oil and gas industry can be boom and bust, but that wasn't the real problem.
What was the problem?
They never defined the roles properly. One person was more of the tech founder, the other was the business strategy founder. That's the way it should have been at least. But because they didn't divide it up this way, they couldn't identify where the real weakness in the company was. It was clear (to me) where the problem was and how it should be fixed.
The point is: it doesn't make sense for everyone to do the same thing. There are lots of tasks to take care of--product development, business strategy, marketing, etc. Some people should do some things. Some should do other things.
Clearly outline roles and tasks from the outset. That way if the business is struggling, it can clearly be pointed out as to where the weaknesses are and who needs to work and concentrate on them. This is NOT to assign blame and to bitch and nag; this is a way to make the company stronger. You and your co-founders need to specialize the hell out of this project.
C. DECIDE HOW MUCH COMPANY EQUITY EACH PERSON SHOULD RECEIVE
Decide on what the ownership of the company should look like.
Unequal splits are good.
A lot of founders do an equal split of 50-50 or 25-25-25-25 even though they shouldn't.
Don't be afraid to have an unequal split. I've seen founders that should not have equal amounts of equity have equal amounts because they weren't objectively thinking about the issues. Having unequal splits solves a lot of deliberation problems and helps keep legal disputes at bay.
Don't be weak on this.
If you think you should have more than 50% then say so. If you think you should have less than 50% then say so. So how do you split the equity pie? Consider:
- What skill is this person bringing?
- How valuable is that skill?
- How integral is this person's role to the business?
- How easily replaceable is this person?
- What else is this person bringing--are they bringing in investments?
- How much time will this person need to spend in order to accomplish the tasks for the company?
- Be objective about the position. If it's a 60-40 split, understand why it should be like that. Have some basis behind the reasoning.
- Don't give something like 1%. 1% at this stage is just bullshit. That's hardly anything and this early on it just complicates matters. You will be giving out 1% of the company later down the road. That being said--dishing out 10% to a founder can be fine and reasonable . . . again, if there is some basis behind the reasoning.
- Remember to be fair and reasonable
The stock that founders receive must be paid for and this payment is in the form of cash, IP, and/or services. More on this particular point in Part 2 of 2 of this series.
D. PROTECT YOURSELF FROM YOUR STARTUP CO-FOUNDERS
How do you do this?
1. GO INTO BUSINESS ONLY WITH PEOPLE YOU TRUST
This is the best and easiest way to protect yourself from a co-founder. You would think this is obvious, but it's not. People get overly optimistic and excited. They get desperate because someone from the outside has a skill-set that would be valuable to their company goals.
It's a little sad honestly.
You know how a buddy gets a little head over heels for someone when dating? And there's really not much you can say to dissuade them from a bad idea? You just want to shake them. It's the same type of thing.
I've seen bad pairings happen many times to disastrous results. Note, however, that even though you love your co-founder dearly, you STILL NEED TO PROTECT YOURSELF WITH PROPER AGREEMENTS.
2. VEST YOUR SHARES
You don't want a situation where you and your co-founder start the company, your co-founder has half of the shares of the startup, and after one month, he says screw this and leaves the company. Why? Because it means that person owns half of the company while you're stuck doing all of the work. Your future investors won't be happy if they see that half of the company is owned by someone who is unreachable and who decided to pursue crab fishing instead of growing the startup.
Therefore, founders' stock needs to be subject to a vesting schedule.
Vesting means that you get your founder's stock but a certain percent of that stock is subject to repurchase by the company if you decide to leave.
The shares that the company can repurchase if you leave are considered unvested. The percentage of stock that the company can repurchase goes down over time according to a vesting schedule until you own all of your shares outright. The shares that the company no longer has a repurchase right for are considered vested to you. After that point, you can do your fishing and still hold on to your shares.
The typical vesting schedule is 4 years with a 1 year cliff. That means that after 1 year with the company 25% of the shares will be vested to you (i.e. the 1 year cliff). Then, for the next 3 years after, the remaining shares will vest on a monthly schedule for a total of 4 years.
i. VESTING ACCELERATION
The vesting schedule can be accelerated on the happening of certain events. You can imagine a situation where you work your ass off for a few years and the company is sold but you don't get rewarded for it because your shares didn't vest by that point. To prevent such a situation, acceleration clauses can often be triggered that will speed up the vesting schedule. There are two types of acceleration:
(a) Single Trigger Acceleration: shares automatically vest in the event of a merger or change of control.
(b) Double Trigger Acceleration: shares automatically vest in the event of two events (e.g. merger + termination of employment.)
3. ANTICIPATE BUSINESS PROBLEMS BEFORE THEY ARISE
Everyone is optimistic and full of promise prior to the start of the company. Everything is going to go great. Have some awareness, however, that it's not always going to be so rosy. There will be problems that arise on some level some where. Try to anticipate where these problems will come from and see how you can prepare for them from the get-go.
4. HAVE WELL DRAFTED BYLAWS AND AGREEMENTS OF THE COMPANY
Bylaws are a company's internal rules that dictate how the company should be governed (in LLCs this is called a company or operating agreement.)
Make sure you address certain issues:
- how disputes of the business should be resolved
- what happens if one co-founder wants to buy the other one out
- how to resolve deadlocks in decision making
- how the company should make important decisions
- what happens upon the dissolution of the business
5. HAVE SHARE TRANSFER RESTRICTIONS
There are many instances where shares may need to be transferred--make sure you address what happens in the event of a death of a co-founder, or if a co-founder gets divorced, or similar.
The typical setup is that shares cannot be transferred except in limited situations (e.g. certain gift transfers) and without the consent of the company. The company needs to have a repurchase right such that if the shares are to be transferred to a third party that the company can repurchase the shares at fair market value.
i. RIGHT OF FIRST REFUSAL
This is a type of share transfer restriction that needs to be in place. You don't want a situation where your co-founder decides to sell their shares to just whoever.
The startup should have a Right of First Refusal stating that if the shareholder wants to sell shares then the company has the right to buy the shares first.
6. ASSIGN IP TO THE COMPANY
I discussed how it's important to make sure that previous and current employers don't own the IP of your startup. It's important to also make sure that your co-founder doesn't own the IP--nor you. The IP needs to belong to the company. That goes for future employees, and other personnel of the company as well.
E. PROTECT YOURSELF AND YOUR COMPANY FROM THE OUTSIDE WORLD
How do you do this?
1. DON'T DO BUSINESS WITH SHADY PEOPLE
Recently I dealt with a situation where one of my clients did business with some shady people. My client naively purchased extremely expensive industrial equipment only to get scammed. DON'T DO BUSINESS WITH THOSE TYPES OF PEOPLE. There are a lot of scummy people out there. This doesn't just happen on the low level either. I had to deal with a situation where a (legit) company in Asia had to process millions of dollars of steel equipment only to figure out that the whole thing was a sham. If you get into a situation like that, it is a massive waste of time and it disrupts you from actually doing real business and operating your company.
The point is--do business with decent people. Don't trust something just because it's a low price. Some things will be much more costly than you realize. If a price is too good to be true, it probably is. Quality costs money.
2. USE PROPER DOCUMENTATION AND HAVE CONTRACTS PROPERLY DRAWN UP
I spoke to some entrepreneurs. They had a fantastic business going, but the whole thing was about to blow up because they didn't have proper contracts in place. They were flying by the seat of their pants and it jeopardized their whole business.
Take the time to have everything properly in place. Have well drafted contracts. Make sure all of your bases are covered. Work on building your system so that you can operate smoothly and without disruption.
3. WORK WITH GOVERNMENT AGENCIES
Don't ignore all of the bureaucratic issues. Yes, you have to file taxes. Yes you have to do informational returns and all of that stuff. Pay your taxes. Keep up to date with governmental filings. If you mess this up you WILL have problems. There is no question about that.
4. HAVE YOUR BOOKS AND CORPORATE DOCUMENTATION PROPERLY SET UP
Yes, you can find yourself in trouble if your corporate documentation isn't properly set up. But just as importantly, having all of your books and corporate documentation in order goes to show accountability and is a sign that you and your company are on top of your shit.
Remember: how you do anything is how you do everything
F. PROTECT YOURSELF AND YOUR STARTUP FROM INVESTORS
When you get outside investors to invest in your company the game changes substantially. You are selling a part of your company. This means that you are giving away certain rights and privileges. Protecting yourself from investors is a big deal. At this point in the game, you don't have to worry much about this. But it is something that will come up. Understand the issues. Know the game being played, internalize it, and you'll be fine.
One area where you will have to protect yourself from is protecting yourself from being excessively diluted. This is something to be mindful of from the get-go.
1. UNDERSTANDING DILUTION
Dilution is where your ownership percentage of the company goes down.
Why does it go down?
It goes down because more stock is issued to others. If you have 10 shares and your co-founder has 10 shares you each own 50% of the company. If 10 shares are also then issued to a third co-founder, then you each own 33% of the company. The number of shares you own doesn't change, but the ownership percentage went down from 50% to 33%.
Founders' stock/common stock does not have anti-dilution protection. Anti-dilution protection is for preferred stock.
The important point to realize is that the more you issue equity and shares to others, the more you will get diluted. That's the trade-off.
2. TYPE OF STOCK
You have to be careful as to how you protect yourself from investors. Likewise, be conscious of the fact that investors will protect themselves from you. Investors will receive preferred stock while the founders will receive simply common stock.
This Founder's stock is just regular common stock and is the same type of stock future employees and personnel will receive.
Don't worry too much about preferred for now. Just know that that's something that will come up.
3. OTHER WAYS TO PROTECT YOUR STARTUP
There are other ways and avenues to think about when protecting your entity from investors. Don't worry too much about those now. When you're ready for it. Read Phase 3 for guidance on that.
Once you've understood how to sort out employment matters, how and what equity is to be divided up, etc., and how to protect yourself from others you're ready to put all of this to practice step by step.
SEE PART 2 OF 2 OF THIS ARTICLE FOR APPLICATION OF THESE PRINCIPLES AND FOR STEP BY STEP INSTRUCTIONS