McStartup

It's been a bit since I've been able to get to the questions, however I will be making a couple of posts this week to catch up.  Last week I had the opportunity to speak at an inspiring event, the Entrepreneurial Bootcamp, which is a forum designed to bring entrepreneurial minded college students together with business veterans.  I was part of a panel called "War Stories," and also judged an elevator pitch competition as the finale of the evening.  I'll post more about that event shortly.

This question is a followup to my previous answer regarding the structuring of founder's equity.  

Christian writes:

Your site is excellent and I'm very impressed with the quality of writing!  It's very balanced and one of the few places that actually weighs the differences between LLC and C-Corp, where most just give a very one sided view.

My question is regarding free riders.  I have an excellent attorney who before incorporating my C-Corp has asked me to prepare a letter of agreement with my business partner going over numerous terms such as confidentiality, non-solicitation, etc.  She wanted me to think about how I would handle the situation where a founding partner stops performing his job functions and benefits from ownership of the company.

The solution sounds like it would be similar to the way founders shares are laid out, but I can't quite hit upon the answer myself.

Could you provide any insight?

Thanks for the compliment.  First, I suppose it's important to define what a "free rider" is.  Assuming your attorney used this term, it would be important to ask them what specifically they mean, because this is one of those ambiguous business terms that can mean different things to different people.

Usually the term "free rider" means someone that has somehow acquired equity in a company, but is not actually providing any value to the organization in order to substantiate that ownership stake--hence they are getting a "free ride" along with your success.

The most common set of circumstances (that I've seen) which leads to the creation of a free rider is poorly constructed founder's equity.  So, to answer your question simply:  Yes.  My post about founder's equity does directly address the issue of free riders.

When you go into business, it's easy to think about just splitting up the shares and jumping in.  However, you can't lose sight of the fact that sometimes things don't go according to plan.  Founders might not work well together.  Your friend might not be the great sales guy you thought he was.  Someone might have family obligations that pull them away from the company.  Someone might leave so they can pursue their dream of becoming a ninja.  Who knows.

The point is, you want to plan for these contingencies.  Founders stock is a way to do that.  What you have described -- a letter of agreement that states what happens in situations X,Y, and Z, is another way to do that.  In fact, a letter of agreement, depending on your attorney, might be the only difference between common stock and "founders stock".  

You should ask your attorney if the letter of agreement deals with all the issues I've outlined in these two posts.  It probably does, and it probably goes further in non-compete agreements, invention assignment agreements, and confidentiality agreements.  Those are all good issues to cover as well (which again, I can go into if someone would like to ask).

An underlying point is that these agreemens should, generally, favor the company while still providing a fair framework.  If Joe needs to leave because a family member has become critically ill, the agreement should probably be that any still-restriced shares (or unvested options), return to the company.  If you want to make an exception for Joe, and let him keep some or all of it based on his circumstances, that should be a decision made by the company, at the time of Joe's departure, after weighing all the circumstances.  Perhaps you let him keep some extra stock.  Perhaps you expect him to return, so you stop lifting the restrictions (or stop the vesting) while he's gone, but let him pick up where he left off if/when he comes back.  

There are lots of ways to deal with the unique situations that come up, and believe me, 95% of situations where a founder leaves will seem pretty unique when they happen.  You should always try to be fair to your employees and partners and can adjust accordingly any plans you have laid out in these agreements.  But the point is that you want the starting point to be in favor of the company, and then have the flexibility to adjust from there.

As promised, here is the follow-up question submitted by Jon who is debating the merits of selecting an LLC or a C-Corporation or an S-Corporation, as well as wondering where to setup such an organization.

In general, I would lean to forming an LLC because it's very easy to setup, you can do it yourself, and the fees for setting it up (not counting California) are pretty inexpensive.  You gain the limited liability that you need, and you get pass through accounting for profits and losses without the "double taxation" you have with a C-Corporation.

Sounds great, right?  Well in most cases, it is, and this is is why you see so many businesses setup as LLCs today.  My first business was an S-Corp, which offered many of the same benefits, but this was before LLCs even existed.  Since then, all of my businesses have started as LLCs.  As they grew, they changed to C-Corporations for reasons I'll explain below.

Jon writes:

First off, I guess for what type of entity to setup the main issue I had originally was whether to be an S corp or LLC.  It seems those 2 would be the best ways to go for my buddy as far as protecting his personal assets and the pass through taxation.  LLC seems a bit more flexible than S corp, but the LLC has to pay SE taxes, where I think the S corp either doesn't (or gets to deduct them).  Both LLC and S corp avoid the double taxation that a C corp would bring on, right?  

LLCs vs. S-Corporations 

S-Corporations are subject to many of the same record keeping and procedural requirements as C-Corporations, which is probably something you don't want to mess around with.  Likewise, there are also limitations on how you share profits and losses among the shareholders.  You probably don't want to mess with that, and LLCs allow you to avoid all that paperwork, and to split profits and losses however your LLC Operating Agreement dictates, regardless of actual shares held.

There are situations where you would want an S-Corp over an LLC, but those are somewhat rare and I've never seen a recent startup need to setup that way.  Here again, an attorney might have good advice, but I'll say with pretty high confidence that an LLC is the way to go over an S-Corp for a startup.

Now LLC vs. C-Corporation is a different matter, and might warrant some consideration... 

LLCs vs. C-Corporations 

The most obvious problem with C-Corporations is that they do not offer the pass through accounting that LLCs (or S-Corps) do, meaning that the Corporation will pay tax on any profits it has, the owner will be paid with a salary just like any other employee, on which they will pay taxes, and if you make profit distributions (by means of dividends), the shareholders will be taxed on that as well.  I could easily climb on my soapbox and complain how taxation of dividends is double taxation on the exact same income, and how it leads corporations to make decisions that are not in the best interest of shareholders, and how it encourages gigantic, multi-national, and anti-competitive business evolution rather than profitable, innovative, smaller entities... but THAT is for another day (and probably another blog entirely!)

But, suffice it to say that the tax code is not friendly to the C-Corporation that wants to operate and then provide profits to the shareholders.  If those shareholders also work there, then are three different points of taxation.  LLCs look like they have only one, but in reality there is a secret second point of taxation because you have to pay self-employment tax in addition to income tax.  Don't you love how the government tries really hard to discourage people from working for themselves in the tax code, while paying lip service to how small business drives the economy?  Ah, there I go again...

Anyway, paying self employment tax is still (most likely) cheaper than the C-Corp tax, because when you are paid as an employee, the C-Corp will need to make an employment tax withholding on your salary which is essentially the same as the self employment tax.  One difference is that with the C-Corp, you might well hold profits in the corporation rather than pay them out, so if you were going to be highly profitable, you might be better served to hold profits there (and avoiding, for a while, the extra taxation) while paying yourself a minimal salary.  

Now in a company that's going to experience a period of losses as things ramp up, the LLC has advantages to the owner-operator.  LLCs will pass those losses along, and those loses can offset other income the individual might have.  In a C-corp, the corporation will carry those losses (for credit against future profits), but the owner-operator, who is an employee, does not get to take those losses.  They will have W-2 income and will be taxed accordingly, just as they would if they were an employee at McDonalds or anyplace else.

So ready to jump right in as an LLC?  Not so fast -- there are a few more considerations...

The biggest limitation of LLCs, in my experience, is the very limited nature of how you deal with the ownership structure.  LLCs do not have shareholders and shares of stock, they have "members" and "units" (nomenclature that is sure to make any fan of 9th grade humor to laugh uncontrollably).  On the surface, it may seem that these are just different names for the same thing, but that's not the case.

In an LLC, one member is the same as another member.  Everyone is working under the same operating agreement, and if I have 100 units, and you have 100 units, there is no difference between us.  An investor, the owner, other employees who have been given ownership -- all these people hold exactly the same type of equity, the unit, and there is no difference between them.  There is only one kind of unit in an LLC, and that's that.

C-Corporations are very different.  C-Corporations can issue different classes of stock, so an investor might have preferred stock, employees and owners common stock.  Those classes can be subdivided further so a investor today might get "Series A Preferred Stock" with certain rights and privileges, and a later investors get "Series B Preferred Stock" with different rights, etc.  You might setup a stock option plan for employees to give them ownership in exchange for their work and loyalty to the company, while the owners have common stock, perhaps with a founders stock agreement as described in an earlier question.  Vendors might get warrants in exchange for providing discounted services.

In short, there is a lot more flexibility here.  Also, there are tax implications.  Because an LLC has one kind of unit, the tax is very simple, and perhaps, not very helpful.  If an investor puts in money at $10 / unit, and you then give away 100 units to an employee because you want to give them ownership, then you've just subjected that employee to a tax hit.  The IRS will say that you "gave" the employee $1000 worth of stuff ($10 * 100 units), and they'll owe income tax, at ordinary income levels, on that gain.  So now your good intentions just cost your employee $300+ in taxes.  They probably won't like that.  So they can either shell out $1000 for the units (fair market value), or you can give them cash along with the units (which they'll also have to pay tax on), so that they can use that cash to pay for the tax on the units you gave them.  Especially when you talk about bringing in management team members, who might demand big pieces of ownership, you quickly can have yourself a real mess.

In the C-Corp, you are probably going to create a stock option plan, and use that to give ownership to employees.  So long as the option price is equal to the fair market value of the underlying class of stock - at the time the option was granted - there is not taxable event.  The expectation is that the company will grow, and by the time the employee vests the stock, it will be worth a lot more than it was when it was granted.  The employee will then have to pay tax on the gain if and when they exercise those options, but normally they don't exercise until they intend to cash in those options, and so they are simply paying tax on actual cash they just received, and everyone is happy.  It's short term capital gain and not long term capital gain, but when you sell to Google for a cool billion, everyone will be pleased.

A fine point in this is to understand that, in a C-Corporation, all classes of stock are not created equal, and therefore, are not priced the same.  Just because an investor buys preferred shares at $10/share does not at all mean that your common shares are also worth $10/share or that your base option price is therefore $10/share.   The preferred shares have all kinds of things that make them more valuable, and no knowledgeable person would pay $10 for common when the same $10 gets them a whole lot more with preferred.  The board of directors will set the price of common, noted in the minutes, with an explanation of why it's so much less than the preferred shares.  It's not uncommon for this discount to be 90% (or more) in a new startup, so a $10 preferred price might mean $1 (or less) for common shares and thus option exercise price.

Summary

What's it all mean?  Well, here's what I do:  When I setup a new company, either on my own or with partners, we setup an LLC.  At the point that we need to start dolling out stock options in order to hire more people, or that we need to bring in outside investors, we convert to a C-Corporation.  When you're talking investors and employee option pools, C-Corporations are the way to go.  If it's just you and some partners trying to make a few bucks, go with the LLC.

If you are only going to raise a little money and never any more, then you can do that with an LLC, but be careful: the last thing you need is a big group of investors, who put money in at all different times in the company's life, with no real distinction or flexibility in how those shares/units work. 

This next question is a somewhat complex two-parter.  Here, I address the question of "what state should I incorporate in?".  In a separate post, I'll address the type of corporation to setup (c-corp, LLC, something else).  I'll try to do part two tomorrow.

Jon writes:

We are looking at where would be the best state to incorporate and I have, of course, always heard Delaware is a great state to do that in.  Nevada as well.  Also, fyi we have determined that an LLC would probably be best for him as I've already done research in that area (unless you have other suggestions).  Anyway, as far as what state to incorp in ... most of the business would most likely be in Cali so do you think it would just be easier to incorp there?  I know Delaware and Nevada have their advantages, but I've also read and heard about the issues/added expenses with doing business in other states as a "foreign corp", which we'd be doing if we incorporated in Delaware or Nevada. 

Additional info you may want to know that could stir some advice from you:

1. He will probably have 3 or 4 private investors
2. Will obviously start out small but will never get very big.  Probably a max of 10-20 employees when it is in full stride.
3. Will probably open an office in LA in a year or so
4. I will be doing the accounting from Indy
5. He may do some work in NC and Florida as well

Well Jon, the first thing I'd suggest your client do is to follow my earlier advice and find a good law firm.  In this case, you may want to look to an entertainment focused firm, of which many are based out of L.A.   Keeping in mind what I had said earlier about attorneys, one of the value-adds you get out of your law firm is another set of eyes and ears in your industry, and they might turn out to be a great source of leads and other industry insights if you were to get the right firm.

All that said, you question is one that is best answered by a lawyer who can explain all of the details and help you make your decisions.  I'll do my best here to provide some high level advice and things to think about.

In general, I would lean toward setting up in Delaware.  The law there favors corporations, they make it very easy to setup and maintain your business, and the annual fees and things for it are inexpensive.  In the future, if someone were to acquire the business, there are pretty good odds that the acquiring business is also setup in Delaware, helping to make the transaction a bit smoother.

That said, in my experience that various tax advantages and things that you hear about are really not there.  Delaware itself will be favorable, but then when you're setup in Indiana, or California, or wherever, you're going to have to file in that state as a foreign entity, and they're going to take their piece of the action as well.  So, for example, just because you setup your LLC in Delaware for say $100 a year does not mean that California (if that's where your office is) is going to sit back and not make you pay the $800 minimum LLC fee every year to them. 

(As a side note, I can tell you from experience that the California state government is a slow moving, technologically  backwards, over-charging behemoth who, for this business, you're going to inevitably deal with.  All the more reason to find a California-based law firm, even if they're not your main one.)  

Clearly, here's a case where the company will need to rely upon the expertise of their attorney and accountant to wade through the red tape.  It can be a mess, believe me.  However, in my experience setting up in Delaware, or not setting up in Delaware, doesn't change the amount of garbage administrative work hardly at all.  Delaware is very cheap and easy, and it's the other states that seem to add the complexity.  

 Also, keep in mind that from a contract standpoint, you're going to be signing contracts that will almost always state that, for that contract, you'll be governed by the laws of the state that your client is in.  So, you indicated that you might have business in California, Florida, and North Carolina.  You'll invariably be under those state laws when it comes to contract enforcement.  Since you're going to be dealing with numerous states anyway, I don't believe this should really effect your decision on where to incorporate, but it's something to keep in mind.

So if it were me, I'd ask my attorney, but I would be inclined to setup in Delaware because it's cheap, it might help down the road, and that's what most other companies are going to do.

You also asked about setting up as an LLC vs. a C-Corp or otherwise.  I'm going to save that for another post here, because I think it's a topic worth of some discussion. 

Thanks for stopping by the site, I hope this helps! 

This next question comes from Brian, who has had a problem in the past with a member of the founding team getting cold feet after the venture was started, and then refusing to give up the equity he had been given.  In this particular case the founder in question hung around with substantial equity, held bitter feelings toward the rest of the team, and made funding awkward and difficult.  His question pertains not to his current situation, but how to avoid it in the future.

Brian writes:

How should we structure the founders equity so that we don't get stuck in a situation where a founder leaves and keeps all his or her stock?

This is an area that many startups, especially when founded by first time entrepreneurs, don't even think about.  They decide how the company should be split up, dole out the shares of stock, and proceed down their happy path.

This is great, until someone decides to leave early, or otherwise makes a troublemaker out of themselves.

The solution is really quite simple, but isn't obvious unless you've dealt with it before.  You can create "Founders Shares" which are really just common shares but are subject to certain restrictions you would not have as a simple shareholder.

These shares are made subject to a "right of repurchase in favor of the company" which is a fancy way of saying that, if you leave, the company has the right, at its sole discretion, to buy the shares back.  These restrictions then "lift" over time, meaning that as time goes on, fewer shares are subject to this repurchase agreement.

For example, lets say that Bill has 1,000 shares of common stock, subject to the founders stock agreement.  Under this agreement, all of his shares are subject to repurchase at any time if he leaves the company (or is fired).  At the same time, 250 shares per year will have their restrictions lifted, provided old Bill here is still with the company.

Ok, so in month 26 of his tenure with the company, Bill has an epiphany, decides to become a ninja, and moves to a monastery in a remote part of Japan to begin his studies.  Good for Bill.  In this case, Bill has been with the company for just over 2 years, so he has 500 shares (250 for each year) free and clear of any founders restrictions.  He keeps those, and the company buys back, at the current share price (or at a previously agreed upon price, maybe what he paid for them) the remaining 500 shares.  Bill is happy with his new ninja friends, and the company is happy to have parted ways in a fair and amicable fashion.

Basically, the founders shares end up working like employee stock options that vest over time (and if you aren't' clear on that, then just ask and I can go into it).  There are two key advantages, however, that favor the founders using this restricted stock format.  One, the founders agreement should state that the owner of the restricted stock can vote their shares as though they were not under any kind of restriction.  That means that, so long as Bill is still with the company, he can vote all 1,000 of his shares even though most or all of them might still be subject to restrictions.  The second is that, because Bill actually bought the shares, his holding period of tax purposes begins at the company's founding, as opposed to (if he held employee stock options), when he exercised those options.  

While most founders are hardly worried about tax consequences at day 1, this is still something worth considering.  If the company is purchased and cash is given for the shares, then you'll be much happier to be in the 15% long term capital gains bracket than at the much higher short term capital gains bracket.  

Finally, founders agreements will often contain accelerators in the event of a liquidation or sale of the company.  For example, say that in year one, Google comes along and buys your company.  From our example, Old Bill had 1000 shares, yet all of them are still subject to repurchase by the company.  Is the evil board of directors going to fire Bill immediately prior to the acquisition, so that it can purchase his shares back for cheap, pocket the cash, and leave Bill hung out to dry?  Unlikely, but it could happen.  This can be addressed by including accelerators stating that, immediately prior to an acquisition or liquidation, or upon termination immediately preceding such an event, all restrictions (or a portion of them) lift.  With this little gem, even if they give Bill the axe (they didn't like his infatuation with ninjas anyway), he'll get to keep his shares because of the accelerators.

You can also do with with your employee stock options if you like, however you need to be careful because a company that acquires you isn't going to want all your employees bailing on day one because they've all received their stock.  Again, employee stock option structuring is probably for another question, but you have to balance what you give to your employees vs. what you can actually make work in the real world.  They are many examples of mergers that didn't go through because the stock options were structured in a way to put all the risk on the acquiring company, and it's just not worth it.

I hope this is helpful.  As always, if there are follow-up questions, ask away. 

This next question comes from Chad. He raises some interesting points which go beyond my areas of expertise.  However, what I can do is tell him (and you) how I would approach this situation if I were in his shoes.  This particular question demonstrates how important finding quality legal advice really is. 

Chad's business is Intimate Journeys, a business that creates romantic dinner settings inspired by a trip he and his wife took to Fiji.  Based on his question below, I assume he is partnering with area restaurants to provide the food and drink, while his focus is on providing the atmosphere and service for the dinner. 

Chad writes:

I am in the process of starting up a very unique business and I am having trouble finding out exactly how and what to license my business as, and the permits I need to obtain. My business works with a much larger company, and I am not sure if their license/permits would cover me. We are a private dining company who uses food from an existing hotel/restaurant and takes clients away from the restaurants to remote locations. We would like to serve beer/wine, but not sure if obtaining the alcohol from the restaurant forgives the fact we have to obtain a permit since we are actually not "selling" liquor. Furthermore, does having the clients bring there own wine, and charging a cork fee change that?

Sounds like you have a pretty interesting business.  Business licensing requirements, especially those related to alcohol sales, vary wildly from one locality to the next.  So the truth is that I really have no idea what the answer to your question is.

However, what I can share is how I would approach this situation if it were my business.

First off, you need to get yourself a good attorney.  Now before you go jumping around the room screaming "I can't afford that!" there are a few things you need to know.  One, if you violate liquor laws, then you've really got something you can't afford on your hands with fines, lawyer costs, or worse.  Second, and more importantly, is that if you look around, you can very often find attorneys that are willing to work with startups for some sort of deferred compensation.

In the past, I've used large firms for two reasons.  One, they had the depth of expertise to span a wide variety of issues.  Two, they were willing to provide, in our case, up to $20,000 of legal work that wasn't payable until we hit certain revenue numbers as a company.  I know of some smaller firms that also do this same kind of thing. 

So if I were you, I would start asking around to see if you can find a firm that would do this.  Even calling a firm you believe to be reputable, stating that you are a startup and would like to talk to someone about legal services, would be a place to start.  Selecting an attorney is not something to be taken lightly, and you should talk to quite a few just as you would when hiring a new employee.  

You're also going to want to find a good insurance agent, who is familiar with your type of business.  Because of the somewhat complex relationship you have as a middle-man between customers and vendors, ensuring that you are properly covered if, for example, your customer gets food poisoning from the fare of a third-party restaurant, is important.  Again, ask around and see if you can find referrals, and talk to a good handful of candidates.  You might ask some of your restaurant partners who they use, and that would give you a starting point there.

I know you're thinking "I don't have time for that, I've got customers to deal with!"  But believe me, these are really critical choices, and are the kinds of decisions that are often glossed over, yet can make a huge difference in your likelihood of success.

As for your specific question about liquor licenses, as I said, I don't know.  But, if I had to guess, I'd say you are probably in some kind of gray area.  As a result, I would document any kind of research you do, and any conversations you have with, say, a local or state agency that indicates you don't need to worry about it.  A good paper trail might not get you off the hook of some bloodthirsty district attorney decides you're violating the law, but being able to show a good faith effort toward doing the right thing is going to be your number one defense outside of an actual court ruling on your type of business.  So document well, and keep those records secure -- just in case.

Again though, your attorney will play a valuable role in determining what actions to take both for this decision, as well as decisions in the future.  Do not underestimate the value they can play.  Attorneys tend to be plugged into the business community at large, and are often a source of additional contacts, potential employees, business partners, and the like.  This is why it's so important to find a good one, and I encourage you to do your research.  There are a handful of great attorneys, a whole bunch of middle-of-the-road ones, and a few bad apples.  You want to find the great ones, and, just as when hiring employees, you want to interview thoroughly, research completely, hire slowly, and if they aren't working out, fire quickly.