Pawan Kumar

Starting a new company is exciting, but it also comes with a range of legal and financial considerations that can be overwhelming for first-time founders. Kirsty Nathoo and Carolynn Levy from Y Combinator, share crucial advice on the legal and accounting basics every entrepreneur should know. In this blog, we’ll break down their insights into practical steps to help you navigate the complex landscape of forming and running a startup. The lecture is available here.

Why Delaware is the Ideal State for Incorporation

When deciding where to form your company, Delaware is often the best choice. Y Combinator recommends it as the go-to state for incorporating startups, primarily due to its well-established legal system and familiarity with investors. Delaware has laws that are friendly to startups and investors, making it easier to raise capital. It also has a reputation that makes investors comfortable, which can be a significant advantage when you’re seeking funding. Choosing the wrong state to incorporate in can be costly and time-consuming. In one case, a startup had to spend over $500,000 to fix a conversion error related to choosing the wrong state. By incorporating in Delaware, founders can avoid such costly mistakes and save valuable time.

Keep Things Simple with Standard Incorporation

While it may be tempting to create a complex structure to address every possible future scenario, simplicity is key in the early stages. Y Combinator encourages founders to use standard methods, such as incorporating as a Delaware C-Corp, which is the most commonly used structure for tech startups. This not only saves time but also ensures you’re using legal documents that investors are familiar with. There are many online incorporation services, like Clerky, that streamline this process by providing standardized forms and guidance to ensure that your company is set up correctly from the start.

Equity Allocation and Founder Agreements: The Importance of Alignment

One of the most crucial decisions founders face is how to divide equity. Nathoo and Levy emphasize the importance of striving for equal equity allocation among co-founders. Disproportionate equity splits can create problems down the line, signaling potential issues of trust or commitment. For investors, uneven splits can be a red flag, suggesting that the co-founders may not be equally invested in the business’s success.

Additionally, it’s essential to focus on the future, not the past, when allocating equity. Founders should not base equity allocation on past contributions or who had the original idea. Instead, equity should be divided based on the future commitment each founder is willing to make to the company. To solidify this, founders need to sign a stock purchase agreement and an 83(b) election form. These steps are critical to avoid tax complications and ensure that ownership is officially and legally recognized.

Vesting: Protecting the Company and Aligning Incentives

Vesting is another essential concept every founder needs to understand. It’s a mechanism that ensures founders remain committed to the company for a long time before fully acquiring their equity. The standard vesting schedule in Silicon Valley is four years with a one-year cliff. This means that after one year, founders will vest 25% of their shares, and the remaining shares will vest monthly over the next three years. If a founder leaves the company before the one-year mark, they forfeit their unvested shares, which the company can repurchase at the original purchase price.

Vesting is crucial for aligning incentives among founders and ensuring that everyone works toward the long-term success of the startup. Even solo founders should consider vesting their shares, as it shows investors that they are committed to building the business over time. It also sets a strong precedent for when employee stock options are introduced.

Raising Capital: Priced Rounds vs. Unpriced Rounds

There are two primary ways to raise money for a startup: priced rounds and unpriced rounds. Priced rounds, such as Series A or Series B, set a specific valuation for the company and sell shares at that price. However, unpriced rounds, like seed funding, are typically faster to close and use instruments like convertible notes or SAFEs (Simple Agreements for Future Equity). These notes allow investors to provide funding in exchange for the right to convert that investment into equity at a later date, usually during a priced round. The advantage of using convertible notes or SAFEs is that they simplify the process and allow startups to raise money quickly without having to establish a company valuation immediately.

Convertible Notes and SAFEs: How They Work

Convertible notes and SAFEs both allow investors to put money into a startup without receiving equity upfront. Instead, the investment converts into equity during a future priced funding round. These investors don’t have voting rights or shareholder status until the conversion occurs. A key feature of convertible notes and SAFEs is the “valuation cap,” which sets a maximum price at which the investment can convert to equity. This ensures that early investors are protected from significant dilution if the company’s valuation increases before the priced round. For example, if an investor puts in $100,000 with a $5 million valuation cap, but the next round values the company at $20 million, the investor will still receive shares at the lower $5 million valuation, resulting in more shares than new investors.

Avoiding Unsophisticated Investors

When raising capital, it’s crucial to choose your investors wisely. Nathoo and Levy warn against taking money from friends or family who may not fully understand the high-risk nature of startup investments. Unsophisticated investors can cause problems if they don’t understand the long-term nature of startup funding or start requesting their money back prematurely. Instead, focus on accredited investors who are familiar with the risks and can afford to invest without expecting immediate returns. Make sure to keep fundraising simple, using standard documents and being transparent about the terms, including how future dilution might affect ownership stakes.

Financial Responsibilities and Proper Record-Keeping

As a startup founder, keeping your financials in order is crucial not only for smooth operations but also to avoid future legal issues. Y Combinator recommends founders maintain organized records of all business expenses, especially since personal and business finances should never be mixed. Startups can use services like Clerky or inDinero to simplify bookkeeping and ensure everything is in order for tax purposes. Always keep receipts for business-related expenses, as your accountant or CPA will need them when filing taxes. Proper financial management, including tracking your cash position, burn rate, and runway, helps you communicate effectively with investors and avoid financial surprises down the line.

Compensation and Employee Classifications

Nathoo and Levy also stress the importance of paying yourself and your co-founders a reasonable salary. Many founders make the mistake of underpaying themselves to save money, but this can lead to dissatisfaction and even legal issues down the road. Founders should be compensated in line with what’s reasonable for a startup and avoid paying themselves too little or too much. Additionally, proper classification of workers is crucial for legal and tax purposes. Founders must classify workers as either employees or contractors, based on factors like the level of control the company has over their work. Misclassifying workers can lead to tax complications and legal trouble.

Firing Employees and Legal Requirements

Lastly, Nathoo and Levy offer advice on firing employees. If an employee isn’t a good fit, it’s important to act quickly and professionally. Delaying the decision to let someone go can hurt team morale and affect the business. When firing, always follow legal requirements, such as paying any owed wages immediately and ensuring the employee’s access to company systems and data is revoked.

Final Thoughts

In conclusion, navigating the legal and accounting aspects of running a startup can be challenging, but with the right guidance, it’s manageable. By incorporating in Delaware, keeping things simple, ensuring proper equity allocation, understanding vesting, raising capital wisely, and managing finances carefully, founders can set their startups up for success. Remember, staying organized, transparent, and informed will not only protect your company but also help attract the right investors and build a strong foundation for future growth.