Illegally Starting a Company

I have probably broken numerous laws everytime I started a company.  For sure, I didn't follow the advice any lawyer would give you about how a company should be started.  I had another entrepreneur call me recently who was starting a company and wanted to know what he should do about incorporating.  Here is my advice...

There are 3 major legal issues you deal with between the time you start a company and close a round of VC if you are going to raise outside investments (angels, vc, etc) BEFORE you are a revenue-generating company... 

1. Incorporating
2. Agreements with people that work for/with you.
3. The investment papers

Lawyers are a complete and utter waste of money when you are first starting a company.  Your resources are extremely constrained and all the money that goes down the lawyer pit brings no value.  The general rule of thumb I follow is do not hire a lawyer until there is an external force that requires you do so.   You don't need a lawyer just because you are going to put up a website or start developing a product.   I'm sure lawyers strongly disagree with me here.

I have in the past done all of the following when starting a company in the incorporation realm...

• Signed a limited partnership agreement with co-founders spelling out exactly who was putting in and getting out what.  My first lawyer had a near heart attack when he saw I had done this, but it worked out exactly as I desired, making sure all founders were on exactly the same page.
• Had a general lawyer who was a friend of family and had no experience in high-tech or venture fields incorporate as a S-corp as a favor.  My high-priced lawyers later laughed at how this was done.
• Used an online incorporation service to form a corporation for a few hundred dollars.
• Used a major law firm with a large portfolio of venture-backed high-tech companies as clients to incorporate and setup the legal entity for a $7500 retainer and using a good bit of that money.
• Used a major law firm to 'fix' my embarassing online incorporation and create a proper legal entity for a few thousand dollars.

The one thing you find out very quickly is that no matter how badly you embarass yourselves with your new high-priced lawyers once you actually have a growing business showing them what you did in the past, for a couple thousand dollars they can fix it all and make you as good as new.

The key to making agreements for stock or equity is to make sure you have contemplated all of the 'exception' cases.  For example, it is not uncommon to have a founder join a company early on and then drop out of the company before you get very far.  You need to make sure that it is very clear exactly who owns what in those situations.  I could make an entire new post on how multiple founders should allocate stockbut the key points I highlight here are make sure to at a minimum spell out exact amounts of stock and vesting schedules.   If you have founders putting in small amounts of money for additional stock, document exactly what they should get for that money, though if you expect to raise capital it will be better to just make most of your expenses debts that the company owes to you so that the company pays you back later on for it.  From a legal perspective the important part is DON'T waste thousands of dollars getting a lawyer to make sure all the founders agree on how stock is being given out, just make sure you have in writing what you are all agreeing to, and a lawyer can come along later and make agreements that legally reflect that pretty easily.

You will come to a point where you will actually need a lawyer.  If you are raising a small amount of money, like taking some angel money, well then your angel can probably direct you on what you should do from there, but most likely you will need to square away all your finances and spend a few thousand on getting a good convertible note written for that investment.  If you are getting close to raising real VC money, then you need to RUN to the best lawyer in town. 

I have received a term sheet for my company from a VC without having a lawyer, and it created a real problem, because I realized looking at all the terms I didn't want to sign anything without a lawyer providing me a review of it, but I didn't have a lawyer to review it, and the VC wanted an answer pretty quickly.  I learned my lesson from that to have a lawyer setup BEFORE you get that far.

I wouldn't call anything I have done in the past perfect - far from it.   When I start my next company, here is what I am going to do...

Since I have an established relationship with a lawyer that I have generated 6 figure billings for, I have the first part of my plan done, which is to start a relationship with your future lawyer BEFORE you give them any retainer or work.   You want to go meet with one of the high-tech lawyers involved in VC and M&A activity at the best law firm in your town. 

A good lawyer can do a lot of things for you for free as an early startup: help you recruit early employees, introduce you to investors, and generate sales leads.  So don't be a stranger to them.   They WILL also heavily push and prod you to do a few simple and cheap (cheap to a lawyer being a few thouasnd dollars) things to establish your legal entity.  This is where you simply hem, haw, and stall them and just flat out say no when you need to. 

Before you do ANY work with a lawyer as a start-up, have very frank conversations with them about your cash situation and get estimates from them on any work that you want them to do. before they do it.  Ask for updated estimates frequently, and do not be afraid to REFUSE to allow a lawyer to do something they want that you really don't need yet.  In large part, lawyers are not interested in you that early on, all they want is to have you standing by so that when you have real legal activity like closing on a VC round they are the ones that rack up that huge bill with you, so use that carrot as your incentive to get all the free help possible when you don't have the money.  Lawyers I have worked with won't do real legal work for free, but will give you lots of advice and help for free, so take advantage of it.  YMMV.

I will avoid creating any kind of legal entity and operate entirely as an individual from a legal perspective until I am going to start revenue generation or take in outside investment capital.  Once that happens, I will call up my lawyer and give them the GREEN light (and have my retainer check for a few thousand sent over to them) and they will whip up my premade company in a box from their legal software in no time flat.

Comments

[Denny K Miu]

Thanks for a great post and a great site.

LLC (Limited Liability Company) registered with the State of California is a good vehicle for starting a company. LLC is an interesting hybrid. Legally it is not a corporation but more like a partnership. And it is an effective shield for limiting your personal liability the same way that a corporation would, yet at the same time, doesn’t require the declaration of a liability-bearing general partner which is what you have to do with a LLP.

Also, from the customer perspective, an LLC sounds a lot like a corporation so it doesn’t have the stigma that comes with an LLP (people think of dentist, doctor and lawyer when you present them a business card that says LLP). Just like LLP, an LLC is not a taxable entity so losses and profits can flow directly to the partners. On the other hand, unlike an S-Corporation, the profit and loss can be distributed anyway that is agreeable to the partners and not necessary according to the percentage ownership.

All it takes to form a LLC is an operating agreement which is not even a legal document and does not need to be filed. So you don’t need a lawyer to do what is basically common sense. So be sure you spell out the ownership structure of the LLC (there is no reason why it has to be equal but there is no reason why it cannot be, so whatever is agreeable to all partners is fine). But be sure to spell out the circumstances when a particular partner is deemed non-contributing and therefore can be invited out by the rest of the partnership.

Also, spell out what happens to his/her shares if any partner was to resign, to be terminated with and without clause, incapacitated and death (either work-related or not). So a typical solution is to give everyone four years to vest and everyone agree that any shares that are unvested can be repurchased by the remaining partners at the original price.

Also, make sure that everyone agrees to a right-of-first-refusal and a co-sale arrangement so that if one partner decides to sell his/her vested shares, every one else has the right to either buy the shares or to sell part of their own vested shares to the same buyer at the same time. Furthermore, make sure you put a price on the shares so that everyone writes a check and buy the shares outright (which can be very low so that the total is on the order of a few hundred dollars).

This is very important because once the stock is purchased, you have started the clock for capital gain and keep in mind that these are 1244 stock which means that if you keep them for five years (which you probably will since that’s how long it will take to build a company if not more), then only half of your capital gain is taxable. There are other benefits as well but the most important one is that if you ever leave your own startup, you can walk away with property that you already owned and you don’t have to worry about AMT.

On the other hand, for working capital, ask everyone to put in the cash as an interest-bearing loan so that when the company starts making profits, you can get the money back without any tax consequence. And as you continue to bootstrap your company, instead of paying the partners salaries, you can declare dividend which is not subject to self-employment tax.

Finally, when you are ready to take VC money, they will want to bring in a high-power lawyer and chances are that they will want you to form a C-Corporation. By then, you can do a tax-free transfer between assets of the LLC and shares of the new company. The VC’s are going to put a vesting schedule on your new shares which you will need to negotiate. But hopefully by then you have some leverage (like customers and profitability) and you can negotiate from a position of strength.

But the most important issue here is that with a C-Corporation you can start from a clean slate and any amateurish decision that you might have made in the past (which served the purpose at the time) is now completely in the past.

[Denny K Miu]

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http://sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2005/12/07/BUGCMG3PTC1.DTL&type=business