Startup Formation and VC Funding

Startup Formation and VC FundingOne of the most irksome problems faced by entrepreneurs with a good idea is that VC funds lay out a series of conditions regarding startup formation that have nothing to with the idea or its business sector. This is mostly about ensuring that the legal framework for the startup will be rock solid.

Everything from the type of entity to its location and the intellectual property rights have to be sorted out before a VC fund will even give you the time of the day.

Let’s just say that a lawyer is one of the essential cogs in the machine that will move your idea from theory to a funded startup. The problem again is that many budding entrepreneurs who come up great ideas don’t have enough money to hire a lawyer, let alone seed a business.

Let’s posit at this point, with some trepidation, that lawyers and bankers can be trusted. Pitch the lawyer or banker as you would a VC fund. If your idea strikes them as being doable, most lawyers will agree to work on a percentage basis, to be paid after you get the funding.

Another possibility, especially applicable for bankers, is to get them to help with the startup formation. Some bankers in places like Silicon Valley and Boston have good connections with VC funds, and they’ll set up meetings for you. Now that you know where to start, let’s get down to the nitty-gritty of startup formation.

Business Structure: If you ask an ordinary lawyer what type of entity your business should register as, they will tell you it depends on the type of business, tax considerations and the amount of capital you’re investing into it on a personal basis.

In other words, if you don’t want to face double taxation and you want to keep the company’s accounting simple and easy to manage, go for an LLC. But ask lawyers who have experience with startups in need of VC funding, and they will tell you that an LLC is a non-starter.

No VC is going to let you in the door if you have registered as an LLC. This is because of the pass-through taxation offered to an LLC, and the difficulty in issuing preferred stocks. In order to get VC funding, the business entity has to be a C-Corporation, preferably registered in Delaware.

Note that your actual place of business can be in California or Massachusetts or your own state, and you can still register your business in Delaware. If you have already registered an LLC elsewhere, then you need to either convert it to a C-Corp., or register a new C-Corp in Delaware and merge your LLC with it.

Equity Distribution & Founder Vesting: Now that you have decided to get your C-Corp registered in Delaware, the next question is about the equity. How many shares does your startup need at the time of incorporation? If you don’t have plans to issue stock options to employees, bring in outsiders like VC funds or angel investors, and/or go public with an IPO, then it doesn’t really matter how many shares your startup authorizes initially.

But, if you have plans to do the things mentioned above, then you should start with 10 million shares. Of this, set aside 8-9 million to be divided among the founders, and the rest to hand out as options.

Ten million is not an arbitrary figure, but has been arrived at based on a study of the number of initially authorized shares that best help the buildup to the 20 million shares needed for a successful IPO. Also note that in some states, the filing fee for incorporation can vary depending on the number of shares being authorized. This is true in Delaware, but not in Texas where they have a fixed filing fee.

Another thing to keep in mind is to impose some measure of restraint on the vesting options of the founders for the initial 3-4 years. A founder vesting schedule makes sense since all the co-founders will then have an incentive to continue working for the company without going their separate ways. Secondly, this is another one of the “conditions” imposed by the VC funds, so you don’t really have a choice in this matter.

Intellectual Property Rights: This is a big issue, especially for tech and web-based startups. If you don’t apply for a patent for your idea and buy the internet domains to match, then you don’t really “own” anything.

But as far as the VC funds are concerned, even this and trademarks are not enough. They will poke around in your past to make sure you’re not misappropriating a business model, ideas or proprietary data and plans that belong to your previous employers or business partners.

This is actually a good idea when multiple founders and employees are involved in the startup formation. Make sure everybody involved with the project is abiding by confidentiality clauses and non-disclosure agreements (if any) signed with past employers or business partners.