This Week in Startups - Avoiding Co-Founder legal disputes & C-Corp vs. LLC with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: November 20, 2020

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Hey, everybody, welcome to a very special series we're doing here on this week in startups. I get asked constantly the most basic questions about how to run a startup. And if you get the basics wrong, you are in for pain, suffering, and expense later in your journey. And people will tell you, oh, you don't need to do it right. You can just wing it. It's the worst advice that you could ever get when it comes to. to accounting, legal, human resources, and your tech stack. When you get these things wrong, you have to rip them out. And the time it takes to rip them out and fix them is painful.

So we're starting a series called Legal Basics. Just the basics. Now, you think you might know the basics. You're on your second or third startup, but this stuff changes and evolves. I would say on a cadence that's, you know, every five to ten years. So my law firm, the law firm J-Cal relies on, is called Wilson Sincini. Most people would say this is either the number one, two, or three law firm in the technology space on a global basis. I'm not going to sit here in debate who's one, two, and three. All you need to know is that it's the top, okay, right up there. Now, Becky de Grau works there.

She works at Wilson-Sincini, and she's been there for a long time. She started as an associate. She is now a partner, and she is going to do us all a real favor by defining the basics that you need to know, and then I'm going to help refine the questions I get as an angel for when people get themselves. Let's face it, tripped up. And getting tripped up on legal issues, you heard my little intro there, Becky. I mean, how much of your life is spent when you're working with that, let's call it, year two startup that's got a little bit of venture capital, got a little bit of money now,

how much is clean up work and fixing stuff? If they don't start with us, a lot. And that's an honest answer, right? I mean, like when startups come to us, they do. They will often say, oh, these are really simple things. I'm just going to pull a form off the internet and I'm going to use that. And without fail, they mess something up. And when they mess something up, it cost three, four, five times the amount to actually fix it.

Right. And when you mess something up, there's typically other parties involved. So in my experience, if you mess up something like your employee stock option plan, if you mess up your corporate structure, LLC versus C-Corp versus S-Corp, Now you've got to go back to those people with egg on your face and say, I screwed up. It's always uncomfortable. And then all of a sudden, everybody thinks they're a lawyer because they watched L.A. Law or they read an article on Wikipedia. And that's what I deal with because I literally have been on the phone with some early investors.

I mean, this just literally happened in the last 60 days, where a group of early angel investors who do not know what they're doing, who have never had any success. we're trying to argue with me over the virtuous of an LLC versus a C-Corp. And I was like, if we're running a pizzeria here or a legal practice or an accounting firm or consulting firm, I agree. But I'm not seeing many LLCs going public. I know there are some exceptions to that. So let's start with that. I mean, because this is day one, you need to form a company. You have typically two choices.

LLC or C-Corp, and there's this little weird one called an S-Quart. Corp that lives in between the two, and these determine much of what your life will be like for the next five or 10 years. Explain what each of these is in the most basic terms you can, Becky, and what the standard is in venture-back technology companies. Yeah, absolutely happy to. So LLC is a limited liability company. So what does that mean? The primary feature of that is that they have limited liability.

If you contrast that with a partnership, which we very, very rarely see in our world, LLC members are not liable for the debts of the entity, whereas in a partnership, they are personally liable. So that's where the limited liability part comes from for the LLC. The other important feature of an LLC is how they are taxed. So it's commonly referred to as a pass-through tax treatment. That essentially means that the entity itself is not taxed, and instead the income or losses are distributed down to the individual members who then report that income and losses on their personal tax returns and pay taxes that way. For that reason, that pass-through tax treatment, that's why VCs disfavor LLCs. It doesn't really work with their fund structure, right?

the way vCs are set up, they don't like that pass-through tax treatment. They don't want to receive income losses each year on every single portfolio company and then have to figure out how to distribute that down to their LPs. It's just not tenable. So if you are an LLC and you have a VC that's interested, they're going to ask you to convert to a corporation. So then what is a corporation? So basically, you know, other than the, let's talk about the tax treatment of the corporation

to contrast that to the LLC. When a corporation has income or losses, they report that income loss on their entity tax return and pay taxes. Then the corporation would turn around and pay employees a salary. And the employees also pay taxes on that salary. This is what we commonly refer to as double taxation and why a lot of people say, oh, I don't want to be a corporation because I don't want to get that double taxation. Well, from a practical standpoint, most startups don't have a lot.

lot of income, don't have a lot of reason to pay taxes. Once you do, and you have investors, okay, it's not a bad problem to have, right? You're in the category of high class problem that we're paying dividends. There are dividend paying stocks in the public stock market. And so what really is, and I think it's a perfect explanation, and an example of it might be, for my podcast, this week in startups, I own 100% of it. I do it as a side-hundred, hustle. It's just me and a couple of people. It is, in fact, an LLC because I'm not going to sell it. I'm not looking to have investors in a podcast. That's not what I'm doing. And when if there is a profit and there's a profit the last couple of years and there were in the first, I don't have

to pay double taxes as the host of the show. So if the show throws off $100,000 in profits for the year after, you know, 150 episodes of me doing this, I, Jason Calacanus, pay my taxes, but I don't pay the corporation and I don't have to pay taxes, right? That's how an LLC works. But if I was running, I don't know, a network of podcasts or a podcast software company. And I wanted investors. If those investors came in and let's say the average round has 10 investors in it and you do four rounds of investing. And now it's not uncommon for you and I when we look at a cap table of a company to see 40,

50, 60 investors, correct? Mm-hmm. And that's a decent amount to manage. Now, if half of those, if but half of those are funds, 30 of them, they typically have, like I have in my launch funds, I would say 150 LPs, some people have as few as 50, some people have dual fund structures. Let's pick a number. I don't know.

Would you say 100 LPs is a reasonable number of LPs on the average fund? Yeah. Now you've got 30 names. that have a hundred LPs. Not each one of those LPs pays the same amount. And in fact, those funds would on average have, I don't know, would you say 50 investments per fund? At least. At least.

Maybe let's make it the number 75. So now you got 30 funds, which have 100 investors. 30 times 100 is 3,000. Now you add 75 investments. If but a third of them, 25, have to distribute money, and we're talking tiny amounts of money because there's always age companies, you're talking about 75,000 legal documents, accounting documents that have to be distributed. And that was your point about the untenableness of it, wasn't it?

Absolutely. Yep. And that's why just VCs aren't going to entertain it. Now, would it make sense for a company, or let me just, put it out this way. If you're sure you want to be a venture-backed company, it's a non-starter to be an LLC. So we put that on the side for a second. And if you're going to be a C-Corp, if you are a sole proprietorship and you don't plan on having investors, there's no reason not to be an LLC. What happens if you're starting the company? It's a little bit of an experiment and you don't know. What does that person do? It's year one. It's me and you, and we decide we want to start a pastry delivery service to deliver queen of mons amongst the fine citizens of the Bay Area.

What should we do? Should we start as an LLC and then convert? And then what would that cause us in terms of expense or timing? Because sometimes I do get that from people. What do I do at my project? Yeah. So I mean, if you are going to start as a company and you don't know that you're going to take VC money and you may say, you know what, I want to try to bootstrap this, I want to try to grow it organically, do it on my own. Maybe I'm not going to be that big. And you do expect you're going to have some revenue. Then probably starting as an LLC is the right approach. If you keep it small, you keep it simple, right? In your example, Jason, it's just you and I. Okay, we can sign up a couple of contracts. We can deliver some pastries. Maybe down the road,

we start going into other things and we develop some sort of unique software or, you know, we're going to have some delivery aspect or whatever it is that we're going to add on. It turns into DoorDash. It turns into DoorDash. We start heading that direction. We're going to be rich. We start heading that direction. I love it.

We got investors throwing money at us. Before you take any money, convert to a C-Corp. At that point, if you only have a two-member LLC and you haven't taken in any fundraising, it's actually a really easy process to convert to a corporation. don't wait until you've got you're like you've got lots of employees and you're trying to give them interest in the LLC and oh well I took a couple of friends and family and they didn't make me convert to a corporation but I took their investment so I have them as these investors in my LLC and I don't know if I have it documented properly. As soon as you start adding on all those additional complexities, the conversion is going to cost you a lot more money. You're going to have to go back and talk to all those different. folks and get them to approve the conversion.

So you can totally start that way as long as you keep it small, keep it simple. Once you start getting more complicated, really pause and think, what is the direction that I'm going? Am I starting to venture closer to needing that VC money? Maybe I should make the change today. Perfect. This is a perfect explanation, Becky. I have another edge case I want to talk to you about, which I do see sometimes, which is,

my friend and I are building a piece of software. It's just a little place for us to play poker with our friends in a web browser. So he's a developer. I'm a UX designer. And we built this little app for our friends to play cards because it's COVID and we want to play cards online. This is actually a real situation. I met two friends who did this and they made a nice, elegant little piece of software. and now comes the time to decide if you want to make it into a company.

There is zero legal documents. It was what I would put in the bucket of project. And now the two of them are wondering, maybe they have divergent interest. One of them has a job they love at Google. They don't want to work on this. The other one has a job at, I don't know, Lyft and they don't want to work there. I'm not single out Lyft. It's a great service if Uber's not available.

That's a joke, inside joke. Anyway, putting the inside jokes at, I have always told people to have a very brief email discussion and say, we're going to work on this project together. If it becomes a company, we will own 50-50 of the company together. If we decide to do it, if one person doesn't want to do it, the other person has the right to buy the other person out in the first year for X amount of money and just put it in an email and write it, just a handwriter or something. So you have at least an understanding between the two of you what your goals are.

Because you don't want to incur a bunch of legal expense for a project just to play some cards online with your friends. What should people do when they're in the ideation project phase? Am I giving good advice or bad advice by saying just write up something in plain English? So at least the two of you have some semblance of a discussion. And then what do you see in your job when three people in a dorm room made a poker app to play with their friends and one of them wants to go for their graduate degree and two of them want to make this into a billion dollar company? What happens then? Yeah. So, I mean, I think your advice is good.

I think something in writing is better than nothing, right? Come to a meeting of the minds. Even if you don't document it properly or legally, at least there's something that we can refer back to when, you know, founder number three comes back and says, No, I was supposed to get 75% of the company. You can say, hey, look, I've got this email. Maybe it doesn't have all the right terminology and the right legal terms. But we agreed it was 50-50. Okay.

So we're at least starting from there. Once you actually create the company and whoever is going to be involved, whether it's one or two or some or all, at that point, when you start the company, you want to make sure everything's cleaned up. So if you're going to give somebody some equity who's no longer going to be there, Make sure you get from them a full assignment of all IP of anything related to the business and say, okay, anything related to the business, the business owns. The company owns. And in return, here's some small portion of shares for you. Investors are going to want to see that, going to want

to know that everything is locked up and that some prior person that was involved isn't going to come knocking when the company does really well and say, oh, by the way, I own a big chunk of this. And we've seen this happen. I don't know. Every year we have a public you know, large version of this and who knows how many private ones happened. The most notable examples from, you know, my history that I remember was there was this person who worked on Snapchat. They worked for it on for like 15 minutes. They came back years later and said, I'm the third co-founder.

And they were like, you were in the room, but you did not, you were not a co-founder. And as typically is the case, a horse trade, a debate occurs. it almost never goes to a trial, it settles. But the settlement might wind up being for two or three percent of Snapchat and it might represent, I don't know, $100 million. And you might be giving somebody who happened to be in the room for three weeks and worked on it for 10 days, the equivalent of $10 million a day. This is the cost of doing it wrong.

Absolutely. Absolutely. the default rule is nobody's bound by confidentiality. Nobody is bound by IP assignment. So if I'm in the room and I'm throwing out ideas and I'm helping you build this and coming up with, hey, what if we structured this way? What if we build it that way? I've got a claim unless I sign something and say that says, I don't own this IP. I don't own these ideas the company does.

And you know what? I've had this used against me in my younger years. at one point I was asked to do a project and these very impressive people came to me and said, hey, J. Cow, you're good at this. It happened to be something entertainment related. I'll leave it at that.

We had a nice conversation, you know, over a two-hour four-season lunch. And then I get an email with a PowerPoint presentation with all of my ideas. And in the footer, copyright, you know, this production company. and I was like, oh my God, they just worked me. I'm not the smartest guy in the world, but I'm certainly not dumb. And I wrote them back and I said, just because you just took all of my ideas and put them into a PowerPoint deck and put my name at the bottom of them does not mean you own my ideas.

I never gave you the right to these ideas. And I can tell you specifically, slides one through nine exist in my email, exist in my notes. And my attorney is cede. you need to rip this up. And if you want no rights to any of those, talk to this attorney. Boom. Everybody got back in line.

And then, you know, a reasonable discussion occurred, which was what percentage of this project should we each own? Producer, network, famous person, etc. And then we started the discussion in earnest. But young people get abused and snowed and worked when it comes to IP. Correct?

Correct. Yeah. And a lot of times it's like, oh, we're all buddies. We don't need to sign anything. Everything's great. We're all happy. We're in this together. Until you're not. Until you're not. And there are sophisticated people. You know what? It looks kind of silly when you write everything down and documented and put like, you know, in the first sentence, copyright trademark, Becky DeGrobb, copyright trademark, Jason Gallaghan. That's like it looks silly and corny. But, you know, in the first sentence, copyright trademark, copyright trademark, Jason Gallaghanis. That's like it looks silly and corny. But, you know, you should be taking notes, you should be documenting your contributions, and a simple email. When one of these claims comes up, there was a Facebook case where Eduardo and two or three other co-founders of Facebook magically were removed from the cap table. When they changed the corporate structure, you can read about this in a lot of books. There was a movie The Social Network. And it was about a company that was a social network where a lot of people contributed. And you know what? The people who had the emails with their contributions and SMS, or at the time it was Yahoo Messenger, when they had their contributions all documented, it resulted in a settlement. You can look it up online. I don't know if Wilson represents the company or people in questions. I'll leave you out of that because you represented some of the great people. But those become discoverable. And that is what a judge will look at. And that's what attorneys will look at and say, listen, here is

what the track record says, here's what the preponderance of evidence says, let's make a deal. Am I correct in how these things typically go down? Yeah. No, I think that's a good, good summary. All right. This has been amazing. We now know how to set up a structure. We know a little bit about IP assignment.

That's a whole other thing we could do in another episode. But this has been great, Becky, great advice. If early stage founders want to reach out to you in Wilson Sincini, if they listen to this episode, they know that we have a most favored nation status between my investment firm launch and Wilson Sincini. You take good care of my people? Absolutely. Happy to.

Okay. How do they reach out to Wilson Sincini? I know it's a big giant firm with a lot of big buildings and a lot of expensive lawyers and a whole range of associates, et cetera. Should they be intimidated as a two-person company to come talk to you? or do you want to talk to those companies? They should not be intimidated. We work with very, very early stage people.

I mean, you come in the door and say, I've got an idea. What do I do next? How do I form a company? We love getting involved at that very early stage. So we may work with, you know, the very, very big companies like Google, but we incorporated Google, right? So, you know, we work with them the whole way. So come talk to us. Literally, Wilson Sincini did the.

incorporation papers for Google. That's right. That's just all the way through. We did the financings, the IPO, and now we represent them in their big antitrust cases and all sorts of stuff. We won't get into that, but let me tell you something. That's, let's just say. That's for another topic.

It's another topic. But my God, the politics on that one, I mean, if you really want to do an antitrust, that's the weakest one I've ever seen in my life. That's my opinion, not Wilson. Sincinnis, WSGR.com. I really appreciate you partnering with just the whole firm. I've had so many great friends there. And I can tell you, for those of you listening, it was scary for me to engage with big

firms when I was in my younger years and I didn't have a lot of money in my bank account. And what you find is the really truly great firms, and I put Wilson Sincini up there right at the top, the really great firms, they want to grow with you and they want to get in early. So don't be intimidated. They pick up the phone. They got a nice office, if this COVID thing ends, we're taping this during the time of COVID. They got a beautiful office down in Soma. You let people co-work out of there sometimes.

You've let me your space to co-work when I had some issues. We had to paint my office. You guys let me work out of there for a couple days. So I do appreciate a beautiful office. And we'll see you all next time on another startup legal basics.