The Silicon Valley Investors Club is excited to have Joytika Jit join us for a talk about the process of starting a startup. In her independent legal practice, Joytika worked with dozens of startups and many large institutional investors, such as A16Z and 8VC. She has provided broad advising related to structuring, legal agreements, funding, tax efficiency and IP to startups. You can learn more about Joytika here.
Owning your own startup is one of the best ways to maximize your income (more money for investing!). As a startup lawyer, I am frequently asked about the process of forming a company. When should you incorporate? Why should you incorporate? And, while many sources will give you a few ideas about how to properly set up a company, few attempt to give you a complete guide on what, when, why, where, how, and who. Thus, many potential founders are left frustrated and confused about how and when they should officially start their company.
In this guide, I will explain how and when to get your company going. By the end of this guide, you will have learned:
- When and why you should incorporate
- What type of legal structure to choose, where to incorporate, and how to incorporate
- Why work with a lawyer and who to choose
When and why you should incorporate
Once you have a fairly concrete idea of the product you would like to develop, you should incorporate. This is especially true if you have more than one cofounder. Here are the reasons why:
- Protection: Setting up a corporation will protect you from personal liability for your company’s actions and protect the work you are putting into the product being developed.
- Intellectual Property: Once you have the right legal documents, all intellectual property (IP) you and your collaborators are creating will be owned by your newly formed entity, so you can make sure no one can steal your idea or product. According to Clerky , “IP is often at the heart of a startup’s value, so it is important to make sure that the company can use the IP without any restrictions, even after founders depart.”
- Equity Ownership. The formation process, which includes the creation of formation documents, will allow you to legally define your equity ownership percentage of the company). Founder ownership usually includes restrictions, such as a vesting and cliff period. Founders should talk amongst themselves and then to their lawyer to work out an equity split – it should NOT be 50/50!
- Investment: The formation process is also crucial to accepting investment. A corporate entity is necessary to open a corporate bank account, and a corporate bank account is necessary to accept capital from an investor. In return for investment, investors expect equity. One form of equity is a convertible security, such as a SAFE (“Simple Agreement for Future Equity), which is a founder-friendly agreement that will convert into stock (“future equity”) once your company is ready to price its share. At later stages of fundraising (Series A and beyond), you will be compensating your investors with stock.
- Hiring and Compensation. The formation process, which includes incorporation and the creation of formation documents allows you to use your company’s funds for cash compensation, to set up employer taxes, and to set up a stock plan so you can offer equity compensation. Being able to offer stock compensation will help you attract talent – especially if you are cash-lean in the first few years of starting your company.
- Accounting and Taxation: When done properly, forming the right corporate entity has the potential to save founder(s) a significant amount of money in taxes at both the corporate and personal level. The right lawyers and accountants can help with this. Ask about potential expense write offs, and tax strategies such as QSBS (Qualified Small Business Stock).
Related Article: SVIC’s Guide On How To Invest In Startups – Part I
What type of legal structure to choose, where to incorporate, and how to incorporate
The type of corporate structure you choose depends on what your vision is for your business. Options include:
- Small business: An LLC in your state might be preferable to a c-corporation for a small business, especially if you are certain that you will not have to raise funds from multiple investors. It offers liability protection, lower taxes, less paperwork, and fewer financial reporting requirements than a c-corporation.
- Choosing an s-corp election (see two points further down) can also help you save money in taxes. For example, you might be able to save up to half of your self-employment tax.
- Investors/syndicates: Many investors set up LLCs for personal liability protection, to pool money together if there are multiple investors, to easily transfer LLC membership interests (more easily than selling off the investments directly, especially if you have a very diverse portfolio), and for optics.
- Possibly raising capital after a few years: If you might raise capital a few years in the future, you may want to consider becoming a c-corp that files an s-corp election (Form 2553) to avoid the “double-taxation” of a c-corp. However, once you raise capital or grow past the four necessary conditions of an s-corp election, you will no longer be eligible for these tax savings.
- What’s standard for most startups: In my personal experience and in conversations with folks who have been in the startup ecosystem for years, almost all startups that succeed will fundraise. Capital is necessary to have a runway to discover product-market fit, for attracting and hiring talent, and to scale and grow your company.
- If you want a high-growth, fast-scaling startup: A Delaware (where) c-corp (what) is the necessary choice because:
- Unlimited number of shareholders
- Corporation-friendly laws
- Optics – this is what investors are likely to be familiar and comfortable with, and signals you understand the norms of the startups and the advantages of the structure
- Lower taxes, as DE fees and taxes are lower than California or New York.
How to incorporate
- Small business: To incorporate your LLC, you can do so directly through your state’s “Secretary of State”. You may also choose to pay a service to do this for you, such as Stripe Atlas, Legal Zoom, and Gust.
- For a startup. I’d recommend working with a lawyer. I will detail the reasons why in the next section.
Related Article: SVIC Guide: How to Invest In Startups With Angel Syndicates
Why work with a lawyer and who to work with
Why work with a lawyer?
If you are running a small business, a lawyer will not be necessary. If you want a “high growth, fast-scaling startup”, you should start working with a lawyer. This is because a lawyer will provide personal advice to help you incorporate correctly, create and advise on custom formation documents, and developing a good relationship with the right lawyer is critical to founder success.
- While services such as Clerky or Stripe Atlas can help you incorporate and will give you good templates, these are templates – and sooner or later, you will need a lawyer to review and/or modify them, explain what the terms in the documents mean, and modify them to help you structure your company to suit your vision.
- If you are worried about the cost, here are some considerations about lawyer fees:
- Yes, legal fees are high, and unfortunately, are one of the highest costs of starting a startup and raising capital. However, a good lawyer should be able to save you 10X+ the cost of their fees – in terms of helping you come up with business and fundraising strategies, negotiation for you retaining control and equity, and in not diluting your equity.
- Many lawyers and law firms will defer fees. I usually ask for a deposit/retainer and defer all other fees until post-raise also.
- However, keep in mind that this might lead to a situation in which “you get what you pay for”. I have often worked with founders who have worked with multiple lawyers/firms before me that have deferred fees and are not responsive to questions, not willing to give their clients extra guidance, or help with strategy. Some of these founders have raised millions without understanding the terms they were raising on.
- Talk to your lawyer about what they will do at no charge or at a discounted rate. Personally, I offer a lot of “freebies” to new companies because I would rather not spend my time or billing hours on cleaning up mistakes.
- Remember, your lawyer is human, and being a “good client” is likely to make them work harder for you. I’m not the only one who thinks so. Develop a relationship with a lawyer who wants to see you succeed. Personally, I feel very motivated in helping those who I have worked with throughout their founder journey.
- You will likely pay more if you need to hire a good lawyer to clean up mistakes. You should avoid “legal debt” (for programmers, somewhat analogous to “technical debt”).
- Some examples of “legal debt” I have cleaned up: fixing meaning-altering typos on legal agreements, stock purchases not done correctly (potentially making 83(b) elections invalid, and thus increasing capital gains taxes for the founders), investment terms that could turn toxic for the founders in later rounds unless we could get investors to agree to new terms, founders whose previous lawyers did not explain terms on SAFEs and term sheets so I had to clear up years of misunderstandings…
- A few words can alter the meaning of a legal document or investor negotiation drastically. These documents may not seem important when you are starting your company, but as you grow and bring on investors, this can make the difference in who controls your company (ideally, you and not your investors), and could cost or save you millions of dollars. Having a lawyer who has experience in investor negotiations will also help you retain control and, hopefully, the greatest share of equity.
- It is difficult for non-lawyers to discern the quality of legal paperwork or advice.
- You may not discover your legal documents are of poor quality or have errors until an investor’s legal team reviews them as part of investor due diligence (this would be very bad optics for your company) or another party performs legal due diligence.
Related Interviews: Interview with Annie Duke, Thinking in Bets
Who to choose as a lawyer
- Knowledgeable. Work with someone knowledgeable – paying a few thousand dollars for good advice could save you 10X+ that amount. At the very least, they should specialize in startups.
- A good startup lawyer should have a solid base of knowledge around corporate law, and be able to integrate that knowledge with IP, privacy, and taxation.
- Trustworthy. Work with someone you trust and feel comfortable with.
- Responsive. Work with someone responsive. Almost every time a client comes to me after previously working with a firm, it is because their previous lawyers were not responding to their questions and requests for help.
- Communication. Good communication makes a huge difference in a lawyer-client relationship. According to the American Bar Association, most attorney-client relationships fail because of poor communication.
- Invests Time in You. Your lawyer should ask lots of questions and be willing to spend the time necessary to understand you, your team, and innately understand what your goals are.
- Provide Explanations. In discussing business, tax, legal, or investment strategies, your lawyer should be willing and able to explain why they said “yes” or “no”, be willing to discuss the risks and potential trade offs, and remind you that the final decision is always yours.
- Ask for recommendations.
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What happens next…
As you should have discovered, properly incorporating and forming your company is a crucial step in your success as a founder, or maybe as an investor or small business owner. First, you will want to incorporate your company, hire a lawyer, and complete the formation documents and process with them. After that, you will be ready to focus on developing your product, finding product-market fit, hiring consultants, and raising capital.
Related Article: Angel Investments vs. Stocks: A Practical Guide
The content here is for informational purposes only, and should not be taken as investment advice. All views contained herein are my own and do not represent the views of any other organization.
Silicon Valley Investors Club (SVIC) is a global community of STEM professionals interested in making smarter investment and career decisions.
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