Launching a startup is hard. Early-stage legal doesn’t have to be. As a legal advisor to startups, here are some common questions I receive about for-profit ventures, with relatively simple answers and market standards.*
1. When is the right time to incorporate?
For new entrepreneurs, especially those bootstrapping their ventures, the question of when to incorporate is perhaps the first legal question asked. Although earlier never hurts, there are a few inflection points where incorporating makes particular sense.
Most notable of these is when you and your co-founder are ready to proceed in earnest with a venture. Incorporating at that juncture and signing legal papers setting the equity split can avoid a significant fight regarding disagreement on ownership percentages. Other points where incorporating makes particular sense include when you are ready to start signing contracts, securing intellectual property assets like trademarks or patents, submitting an app to a marketplace like Google Play or the App Store, or hiring employees.
Keep in mind that, prior to forming an appropriate legal entity, the founders have personal liability for the debts of the business.
2. What type of entity should I select?
Once the decision has been made to incorporate, the next question is, incorporate as what? The most common legal entities used for businesses are corporations and limited liability companies (LLCs). Both have their advantages and drawbacks, many of which are related to tax treatment.
If your plan for the company is to raise venture capital investment, re-invest every dollar of revenue in growth and eventually profit from the enterprise through an exit, a Delaware corporation is almost certainly the way to go. Professional investors have a strong affinity for Delaware corporations, they are generally straightforward to put together (i.e., low cost), and it is easier to equitize employees through this vehicle.
If you are going the venture route and select a corporation, it is usually best to keep it simple, starting only with common stock and adding preferred stock down the road as you finance.
If your plan is to generate cash on a yearly basis that you will then distribute to yourself and investors as the primary way to make money from the venture, like in a consulting or professional service firm, an LLC may be a better choice.
3. Should founders’ equity be subject to vesting?
Almost certainly, yes. There are too many situations where the founders’ equity is not subject to a vesting schedule and the founders have a falling out. Such a situation could be addressed in advance through restrictions on the founder’s stock that stipulates how much the founder keeps if they leave the company. Without such an agreement, the founder could walk away with a significant chunk of equity, threatening the ability to raise capital and ultimately, the continued viability of the entire venture.
4. What are the most common forms of early-stage financings, and which should I use?
There are a variety of legal instruments under which an early-stage company can accept financing. These include convertible debt, and newer instruments like SAFEs and KISSes, as well as equity financings.
Many early-stage financings these days are done in the form of convertible debt, which is structured as a loan to the company from investors that automatically or electively converts into equity at various points in the future - for example, when the company closes a preferred stock financing or exits. This instrument has the advantage of deferring valuation until the company is a bit more mature and there are more data available to form the basis of a valuation. It is also relatively low cost, making it attractive for family and friends and pre-seed financings, where the amount of capital being raised does not justify the legal expense of a full-blown preferred equity financing. Variants on this model are SAFEs and KISSes, which are non-debt equity instruments with a deferred valuation.
Although convertible securities have been the most common early-stage financing instrument, there is a recent trend toward priced rounds, even for very new companies. A set of standard terms for this type of financing is emerging, reducing their cost and making them more viable for smaller capital raises.
These issues faced by early-stage companies are common, and although each legal situation is unique and requires all the facts to be examined before concrete advice can be rendered, they can generally be navigated easily with a straightforward approach and attention to market standards and trends.
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