McStartup

This next question is from Matt, who deftly manages to pack three questions into a single message to me, but since he was so kind as to give me some kudos up front, I couldn't resist posting it up here. :)  I will address the first question in this post, others to follow.   This question concerns intellectual property, and what a software startup should do to protect it. 

Matt writes:

Dude, I am totally loving this blog. As a first time entrepreneur facing a steep learning curve, your blog is the perfect resource. Thank you so much for choosing to help us newbies. I hope to be able to do the same one day myself!

So here's my deal...

I am not an engineer (I'm a journalist), but I want to start a search-within-video software company and I am worried that I will get my idea stolen by one of the potential software engineers I interview and/or recruit along the way. Any suggestions as to how I might mitigate this risk? Or is it just part of the territory.

Thanks!
-Matt

(editors note:  two additional questions held back to be answered later)

Discussing intellectual property protection (IP) is worthy of multiple posts on it's own, but allow me to be blunt:  don't worry about it. 

Here are the steps you should take as a software related start-up.  First, have a standard non-disclosure agreement (NDA) and have people sign it when possible *if* you are going to discuss secret details with them.  It is not necessary (or worth the hassle) to try and get everyone and their brother to sign one just because you are going to give them a little insight into your business.  Be aware that potential investors, particularly professionals (like VCs) will seldom sign them, because they'd be under so many NDAs that they could never possibly keep track if they did.

However, keep in mind that an NDA, while a legal agreement, is going to be nearly impossible to enforce.  If someone you talked to, 3 years down the road, comes up with a competing company, how are you going to prove that they stole your intellectual property?  Very challenging, unless you have an engineer that actually stole code or something like that.  Nevertheless, the NDA at least tells the person "Hey, this is secret stuff, and if you tell anyone, I'm going to send my big bad legal team (if I had one) after you!"

Second, with any employees or contractors (particularly the engineers) your are going to want them to sign what's called an invention assignment agreement.  This agreement states that anything they come up with while working for you is the property of the company.  This prevents them from later moving to a competitor and taking their code with them (at least, theoretically and legally). 

Third, you will want to talk to an intellectual property attorney and look into what other kinds of protection you can have for your software.  Filing copyrights is easy, filing patents not-so-much.  Patents will likely cost you well in excess of $10,000 and take years (I was granted my most recent software patent 3 years after I'd already sold the company that filed for the patent.).  A less costly approach is to file what's called a provisional patent, which gives you an additional 12 months (if memory serves me correctly) to file a full patent, and have your invention date backdated to the date you filed the provisional.  That would probably cost a few thousand dollars instead of tens-of-thousands.

Now, all that said, here's the real scoop:  your intellectual property is mostly worthless anyway.

What do I mean?  I mean that your business is going to be 5% IP and 95% execution.  If someone steals your idea, so what?  Let's be honest, if your technology is so simple that someone can hear a few things and copy it, then your technology provided you with no barrier of protection anyway, and all you have is good, old-fashioned, execution on your side.  If your technology is real complicated, then it's not like a casual conversation is going to lead to grand-theft anyway.

So in short, don't worry about it.  I've seen way too many startups hide in the corner with their bright ideas like they were Smegal from Lord of the RIngs shouting "My precious!"  Take the steps I've outlined above (investors will expect NDAs and Invention Assignment agreements in place), talk to a patent attorney (they'll have an introductary meeting with you at no charge), and move on.  You've got a ton of work ahead of you, and you don't need to be worrying about someone stealing your idea. 

To worry about it is like trying to run a race while not being seen.  You'll move slow, you'll look ridiculous, and you'll never win.

I'll hit some of these other questions in a future post.  Good luck!

This question comes from Nina, who has been given the option of buying her way into some equity ownership after spending some time working at the company.  There are a number of things consider here, and perhaps most important is to gain some understand of the difference between being an investor (shareholder) and being an operator in the business (employee).

Nina writes

I have been working in a small design and strategy consultancy for the last 18 months.The company is 3 years old, good cash flow, good contracts and is also dependent on the 3 core consultants (me included). The principal has offered me an option to own some equity because I bring complimentary skills and have a strong working history and we share the same vision for the company. He is proposing that we start the business as if it was from scratch and we each put in an amount of the working capital needed. Then the proportion I put in, represents my share of ownership.

This equity gives me the shared right to business decisions, building the company, and ensuring business sustainability. What do I have to understand, what homework do I need to do to accept this offer? I am interested in equity because I want to build a company and have a role in the day to day decision making.

We the short, yet complex answer is that it will all come down to whatever agreement is reached between the two owners.  Creating a new company, and splitting the equity for this type of business is probably a wise move, as it creates a clean slate to build on, and the nature of the business is consulting. 

However, a few things to keep in mind.  First, equity ownership does not automatically equate to decision making power.  Just as I can't tell Steve Jobs what to do because I own 100 shares of Apple, one owner or the other won't necessarily have the authority to make decisions in day-to-day business operations.  That is probably obvious, but it's worth exploring a bit further, because, by the same token, I could own just one share of Apple stock and have full control over the operations of the company, provided it was the right class of stock.

As it turns out, not all stock is created equal, and different classes of stock very often have different voting rights and abilities (hence the reason for having different classes of stock).  In the structure you have described in your question, each of you should have identical classes of stock, the only difference being how much you each have.  Different classes of stock between the two of you wouldn't make any sense based on what you've said here.

Another thing to think about is that stock ownership has very little to do with day-to-day operational authority.  There are plenty of company presidents and vice-presidents who make all sorts of unilateral decisions in both public and private companies who have very little or no equity ownership at all.  The equity allows you to do is elect a board of directors, and those directors then choose a president.  That's really about it, and at some point, someone has to have the authority to make a decision one way or the other, even if the equity owners disagree on what that decision should be.  You won't disagree very often, but it does happen, and you don't want to be scratching your head as to who gets to make the call when that time comes.  Perhaps it's the person with the most equity, but that's not necessarily the answer, particularly if you might have the option to kick in some extra cash or time and boost your equity some.  What if you both had identical shares - who would make the decision then?

This decision making hierarchy is really something for the two of you to chat about outside the ownership piece, becuase they really are two different issues.  First, understand how the business will function, what your role will be, what the role of the other owner is, where you both envision things going, and so on.  THEN, once you understand the proposed business, ask yourself if you'd like to be an investor in that business, and what returns do you expect as an investor.  Will you each get a salary as employees?  How and why do your salaries differ?  Will dividends be paid out of profits?  Who decides what dividend should be paid?

I believe it's important to think about it that way, because you really are talking about having two different roles in the same business - one as a person that works in the organization, the other as an investor in the company.  Understand what authority you will have and what is expected of you as an employee, and how will you be compensated (if at all).  Then, understand what authority you will have as an investor, and how you will be compensated for that investment.

If you break it down into these two buckets, I think it will make your decision process easier to manage.  In general, my advice would be to pursue getting some ownership in the business, because right now, your are the employee without the ownership, and you have the opportunity for that to change.  However, keep in mind that if you can't reach an agreement that meets your expectations as both employee and investor, then maybe it's time to consider setting up shop on your own (and even then, you'll want to think of yourself as both employee and investor).

Best of luck!

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!