This Week in Startups - Common First-Time Founder Mistakes with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: March 26, 2021

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Hey, everybody, welcome back to our startup basics series here at this week in startups. What is startup basics? Very simple. I could ask the same questions over and over and over again. Will you invest in my company? Show me your traction. Will you invest in my company? Show me your traction.

It's the same conversation over and over again, whether it's raising money, legal issues, accounting issues, or HR issues. And literally, while I'm taping this, there was a board meeting going on that another person our team is going to where they're dealing with the type of legal mistakes that we're trying to help you avoid on today's program. If you make these mistakes, it takes you only one error in judgment to make the mistake. And instead of doing the half hour or hour of two hours of work to not make the mistake and to do it right, you wind up creating 200 hours or 2,000 hours or a busted deal down the road or an acquisition that gets called off. So please, tight is right when it comes to accounting, HR, and legal. Probably most of all legal,

although it's pretty close between accounting and legal. I've seen deals blow up. And with me, again, Becky de Grau, who works at the greatest law firm in Silicon Valley, Wilson-Sensini. I said it. I said it. She won't say it. They're all very magnanimous out here. Hey, listen, Larry Sincini was a legend. And he was Steve Jobs' lawyer. And that's who Steve Jobs went to for advice. I know this because Larry Sincini told me when I had breakfast with him when I was 29 years old. And I met him in New York.

We're going to go over some more issues. Today is kind of a lot of little issues. We're going to try to check a bunch of boxes. We're going to go over five issues, I think. And if you want to see the entire history of this series, including the accounting, and then hopefully we'll find an HR partner to go over the HR stuff with You can go to this week in startups.com.

That's our domain name for the podcast slash basics, as in startup basics. This week in startups.com slash basics. You'll see the whole series there. It's also on YouTube. It's also on the iTunes feed. But for simplicity, we made a landing page so you can just whip through these

with your co-founders and make sure you don't make any mistakes. Okay, here we are, Becky. We've done a lot of great topics. Negotiating a term sheet, employment agreements, financing structures, legal disputes between co-founders.

How to run a board meeting. That one went really well. I got great feedback on that. And we did our deep dive on stock option grants, which is really the fuel in the engine of Silicon Valley. I'm assuming you got some good feedback on the pod so far and the basics. Yeah, yeah, absolutely. There you go.

Now you're a star. Look at that, you're a home podcast, the Wilson's Insini Legal Podcast, coming to you in 2022. All right. So today, we just thought, let's go through your email box. Let's go through your schedule and find all of the repetitive mistakes people make.

Let's go over the first one. A missed 83B election. I think we should explain what an 83B election is first, yeah? Yeah, yeah. Let's take a step back. So when founders buy stock, it's typically restricted stock. And all that means is that it is a stock that is subject to vesting. Okay.

So anytime you buy stock, that is still subject to vesting, there's this election that you can make under the Internal Revenue Code, and it's called an 83B election. So let's just go to what the default rule is if you don't make one of these elections. Okay, so you buy your stock, it's got vesting associated with it. Let's say it vests every month over the next four years, just for nice, easy schedule here. If you don't make an 83B election, what the IRS does is it will tax you on each date that you vest and it'll compare the fair market value on that date to what you bought the stock

at. So maybe your first vesting date, no big deal, right? You probably vest a month later. It's probably still the same fair market value. But let's take a look maybe a year out when your stock starts vesting. The fair market value of that stock, presumably, if you're doing something right, hopefully you're growing, that the value of the company is increasing over time. So, Year out, you have some stock vesting. The IRS is going to say, okay, we, you know, it's, it's five cents per share and you only paid a penny per share. We're going to tax you on the delta between that of the four cents per share.

And they do that every month. And every month as the value goes up, this tax bill can be really painful. So what the 83B election says is you have to file it within 30 days of purchasing your stock, absolutely no exceptions to that. a lot of things in corporate law, we can ratify. We can waive. We can go back and get the right approvals for and fix in a number of regards. This isn't corporate law.

This is IRS. There are no. They do not play games. They don't have a sense of humor about many things. Yeah. I'm not saying they're humorless, but they're not known for their flexibility. Let's leave it at that. Exactly.

Exactly. So this 30 days is a serious 30 days. No, no exception. to it. But if you make the filing within that 30-day period, what the filing says is you're basically telling the IRS, hey, I understand that I may not vest in all of these shares, but I want you to tax me today as though I am vested in all of the shares, and I want to pay tax today on all of it. The beauty of that is, when you buy your shares on day one, you are paying the fair market value for those shares. So the delta between what you pay and the fair market value should be,

zero, which means tax me on zero. Perfect. Great. That's exactly what you want to get taxed on. Sounds fair to me. So that's what the 83B election does. It allows you to get all of that done up front, ensure that you don't have ongoing taxation at different valuations over the course of the period of time that you're vesting. And if you do it right, you have zero tax. Perfect. So this is absolutely critical for you to get right. And it's really easy to do. As a matter of fact, it's no work for the founder.

This is your attorney's job, correct? No. No. Okay, wait, whose job is it? It's the founder's job. It's the founder's job, okay. But we tee it up. Okay.

Well, I mean, if you have an attorney and they don't alert you to this, they're not a startup attorney, are they? No. So literally, this is how we do it. Like, you have your restricted stock purchase agreement, and in the same document as an exhibit to the purchase agreement, we have the 83B election already there, already filled out for you.

We will remind you, we will hassle you. But it's still your responsibility. Okay, I got it. It's your responsibility to actually mail it in. We don't want to be responsible for your tax issue if you don't mail it. Exactly. So get it done. No excuses.

All right. Next up, founders and investors think they own the company, but they didn't actually buy any stock. I get this one all the time. So I will hear, you know what? I incorporated the company. Look, here's my certificate of incorporation. We filed it in Delaware.

I've got the company. Like, okay, great. What other paperwork do you have? Well, I haven't done any other paperwork yet. Okay. But I don't worry. I own the company. I'm the only director.

I'm the only officer. I own 100% of the company. Well, not really. If all you've actually done is incorporate the company, you have a company, but you have to actually appoint. point directors to have a director. You have to actually appoint officers to have authority to act on behalf of that company. You have to have that board of directors actually issue and approve stock. And then you have to actually buy. You have to write a check to the company to buy that stock.

So there's a lot of steps there that have to take place. You don't just automatically own everything. So people are jump at the fence here. They think, oh, I incorporated. I got the paperwork for that. and now it's all done. It's not all done. You actually have to appoint the directors. You got to then have the officers. Officers is a fancy word for people who work at the company, correct? Yeah. You know, like your chief executive officer, your president, like whoever has authority to like sign on behalf of the company. We typically refer to those as officers of the company. And the directors is just another word for your board. Right. So the board of directors has directors. So when people hear directors and officers, that means the directors and the top key employees.

Is there like a specific line where somebody as an officer of the company is just an employee? Is there like some, you know, the sixth person is just, I've never actually known this or is it just. It's usually by title. So the board, so once you have your board, they are the ones who determine who the officers of the company are. So if I'm the board member and I want to appoint you as CFO, I'm going to say, I as the board approve, Jason is CFO of the company. And then now you have officer authority to sign on behalf of the company. As an officer of the company, you will also get picked up by D&O insurance,

directors and officers insurance. But it all stems from that magic approval at the board level. So even if I'm the CEO and I say, I want to hire you as CFO, great. but you don't get the officer title. Officially, you don't get the coverage as officer until the board makes the appointment. Got it. So that's good. I actually learned something today.

I was always wondering, so does that mean if I have a vice president of sales, they're not an officer because it's not in the title, or it's because the board of directors didn't appoint them? Because the board didn't appoint them. Because you can absolutely put your VP of sales in the officer category by just purely having the board say, we're appointing the VP of sales, John Doe, as officer of the company. And conversely, if they do have officer in their title and they weren't actually appointed by the board, they're not an officer. So if you say, hey, I'll give you the CTO title, but I didn't actually get the board to give them that gig, then they are not an officer of the company.

You've got a title, but you don't have the officer authority. Got it, got it. And that means signing for the company legal documents on behalf of the company. Now, if the CTO, let's just come up with a far school question here, the CTO signs an agreement for a million dollars worth of servers, but they weren't an actual officer. Does that make that contract null and void? And then how does the person procuring that, you know, the person who's sold to the millions servers, no, do they ask, do you have signing authority? So on really big contracts, you can get asked that question. Banks, for example, will ask you to do a, an actual certification to show who the officers are. In most instances, your vendor agreements, they're not going to ask for that. And there's this other rule of law called apparent authority. So as a vendor, if I sign up with, in your example, with the CTO of the company for something

related to what a typical CEO would have authority to sign, I can rely on that fact and enforce it against the company of the apparent. authority. And then there will be issues behind the scene as to how that gets handled and things of that nature if the company didn't want to honor it. But ultimately, apparent authority is a real thing. Vendors, suppliers, third parties can rely on that. Oh, that's fascinating. Again, I learned something I didn't know today. I'm 50 years old. I've been in the industry for 30 years. I actually never knew that. I always wondered like how does signing authority work? And is it nebulous? You know, what stops somebody who works at a company from signing 20 agreements to acquire

20 different products or services and then send them to their apartment? And the answer is nothing, but people generally who are in these positions have been vetted. They sign agreements and people generally like to follow the law and not steal. Well, and in that example, the company would have a very nice claim against that employee for all sorts of wrongdoing. Yeah. You would go to jail. as we've seen,

sometimes a presidential pardon will come for people who steal, but I wouldn't rely on it. We'll leave out the names to keep the guilty or pardoned anonymous here. All right, wait until funding to set up a company.

Yes. Tax and valuation issues ensue. This one is always, always, always a major issue because founders want to save money and incorporate rating is, I don't know, it's not expensive, but it's not cheap if you're a first-time founder. You know, and we'll get into that in a minute. But let's talk about this mistake and why it's such a

big mistake. Yeah, I mean, I hear this one all the time too. It's like, yeah, I know I need to set up a company. I know I need to do all of that. But, you know, we're just figuring things out. I'm going to wait until we actually get some traction. I'm going to wait until we get funding. And then I'll, and then I'll just do it all. So there's a couple of big issues why you don't want to do that. So if you, let's just say, you do wait until you get funding. You've got a term sheet on the table. It's nice. You got a series seed financing. Let's just say, you know, they're going to put in $2 million at, I don't know, and $8 million pre-money valuation. Okay. Like, oh, isn't that great? Like, we just landed this. This is exciting.

We're not even incorporated. We're rich. Not even incorporated, but this is amazing. So now, now you reach out to the lawyer and you say, okay, I need to get incorporated. and the lawyer says, okay, great, we got to issue you some stock. Oh, by the way, the valuation of your company now has to take into account the fact that you have a term sheet setting on your desk saying that the value of the company is worth $8 million. Granted, you don't have to issue your stock at $8 million because that's for preferred stock. But you absolutely do have to go and get what we call a 401A valuation report from a third party to say, what is the value of the common stock, assuming that this financing goes through,

it's no longer a thousandth of a penny per share. I can promise you that. I don't know what the value is, but it's a whole lot further north of that. And that's from a founder perspective, one of the biggest reasons why you should be motivated not to wait. You're going to pay a lot for your stock for no reason. Let me ask you a question that you might be a little biased in.

I meet a lot of founders who say, I went on this website and they had incorporation documents or there was a service I paid 500 bucks for and they just incorporated me. You must take on clients who have done this before. Are those services actually okay to use or do they lead to downstream problems? Yes and no. So if you go through one of those services and I think we've seen them all, if you go through one of those services, some are better than others, right? There are. There's some that they're right.

There's a range. The thing about those services is you have to be a little bit on the ball. You have to be proactive. They're going to send you a bunch of documents. And you could say, okay, cool, I got all my documents. This happens a lot too. But you don't sign anything. You don't actually write that check to purchase your stock.

You're kind of back in the same place that we just talked about. You may have all the documents setting in front of you, but you didn't actually take the execution level. You didn't do that. Or maybe you did sign the documents, but you didn't write. the check. That means you still didn't buy the stock. Or you signed the documents, wrote the check, but you didn't file the 83B election. You can see how all these things start to come together. Yep. Yeah. So, I mean, if you do use one of those services, you'll, you might make some mistakes. If you're really detail-oriented, you might get it right. You may or may not. And then hiring an

attorney does cost and doing all the setup, a couple of thousand dollars, I would say, typically, in my experience. So, yeah, you can save some money on the margins. But I always tell everybody, Just do it right. This is not the place to try to save money. Yeah. Yeah. So that's one of the one reasons, right? For founders, you personally, this is going to affect your pocketbook.

This is going to affect how much you pay for your stock. So get it done early. The other thing would be, you know, any type of contracts. Like, what have you done up until this point? Like, you didn't have a company. So if you hired a website developer, you hired somebody to do, you know, write some code for you, that contract must have been between. you personally and that developer.

You now got to get that contract and all the rights under that contract into the company. The old IP assignment now comes to cleanup work. Exactly. So, you know, maybe the third party is amenable to signing a quick, easy, an assignment. No big deal.

You still have to go through the process of getting that assignment. Or they could be like, well, no. You have to pay me. I want 10K more. stuff, hey, we really need this to get done because we're trying to get funding. You just let the cat on the bag to wear the leverages. Exactly.

How much are you raising? $2 million? Great. Sounds like I should get 1% of that because people just assume that $2 million is going in the founder's pockets. This is like one of the great misconceptions of our industry is that when people raise money, they think the founders get the money. That's called a secondary transaction.

That does occur, but not that often. When people invest in a company, it goes to the company, not the employee, or the founder rather, and certainly not the employee. At least not in the early stages, right? Like if you get to like Series B, C, secondaries may be more prevalent. But in the early stages, the money is definitely going to grow the company first and foremost. Here's just a little bit of an aside, 10 years ago, when you were bought an associate coming up in the world, how often did you see secondary shares occurring in a series B versus today?

Out of 10. That's a good question. I would say maybe one, 10 years ago. Yeah. Maybe even less, maybe one in 20 even yet. Yeah. Okay. And then today, Series B? Series B, I would say maybe I'm going to go with like three. Okay, 30% of the time, right. So it's gone probably like 5, 6x. It has become kind of a standard for founders who have a a really competitive deal to just take a little bit off the table. It's very weird how that's become a standard. And I think it has perverted in a way how people pick their investors now, because some investors who don't have their reputation will offer a lot of cash. It's almost like they're buying the deal would be a cynical way to frame it. And then, you know, the elite investors are like,

well, don't we want all the money to go in the company? Aren't we playing for the equity? And they're like, well, I would like to buy my apartment. And it's like, all right, let's, you know, we'll hash it out. But I've seen some folks come in and just be like, I'll give each of the founders a $2 million, $3 million just to get the deal. And then it's, I don't know how you personally feel about it. I don't know if you're allowed to have a personal opinion as an attorney. It does, is my cynical take in some ways accurate that people use it as a way to win deals? I think so. I think they do.

I think it's another material term of the financing to consider, right? when you are setting on the board and making a decision whether to approve the financing, you wear this hat that has fiduciary duties attached to it. Don't I know it. And, you know, in that situation, a founder should not be voting in favor one way or another to approve a deal solely because one has a secondary and the other does not. And we would obviously counsel company in that direction. But if all other terms are equal, there's no reason not to say we're going to go with this deal because it has this extra feature.

I'm so old school now. I find myself like I have these like old school ideas that we should really run things properly. And I find myself asking all these questions and people are like, ah, whatever, you know, like it's standard now. And I'm just like, is it standard? I'm not sure. Sure. What's interesting is I think is I think a lot of the reason that we have moved in this direction is we are definitely in a founder-friendly company-friendly market right now. More so than ever. The pendulum has swung. The pendulum has swung 10 years ago, I think, you know, maybe not. But each year. Somewhere in the middle, yeah.

Yeah. Each year it has gotten more and more and we are definitely squarely. in company founder favorable land right now. Yeah, you know, the other thing I've seen now is this like, we're going to re-up the founder. And I'm like, what does this mean? It's like, we're going to give the founder more shares so they don't get diluted by the financing. And I'm like, I thought the concept of this like cap table was when we make a decision to put more money in the company, everybody takes the hit. The angels, the series A, the employees, and the founder. And they're like, yeah, but we're going to just carve out the founder.

and I literally had somebody say, oh, you know, the founder was at 60% ownership. And this was a 20% dilution event. So they would have gone down to 48% or whatever. And they're like, yeah, we want the founder to stay at 60%. I'm like, what? This makes no sense. I mean, I can see from your reaction, you're like, that doesn't make any sense. That's pretty aggressive.

And you know what I just said? I said, listen, I know that maybe this is cool with you, other VC firm. I can't do this to my LPs. I can't do this to other shareholders. why don't you buy my position? And then I could just get off the board and you could just buy me out. Like, I don't want to be involved in shenanigans because I don't know, maybe I'm crazy, but I have this thing in the back of my head that when this company goes public or gets bought,

somebody's going to pull that out and say, who approved this? And maybe I'm being paranoid, but it felt to me like that was another way of the person winning the deal by offering this refresh as contingent on them leading the round. And I felt that was kind of prenicious. Yeah, it doesn't, it doesn't have nice touchy-feely. No. And I'm like, well, what about the employees who work for you? Yeah.

Who are getting diluted 20% and you're not. At the Friday, all hands, do you want to have that conversation that they took dilution and you didn't? I was like, also, shouldn't these things be separated? Like, I was like, why can't this be a discussion the board has in six months? Why is this tight of financing? That doesn't make sense to me either. Like, shouldn't those things be separate?

Ideally, they should be, right? They're two different transactions. And to your point, you know, if they're coupling them together and conditioning them on each other to try to be more competitive in the eyes of the founder, I see that's why they're doing it. But as the board, I mean, ultimately, it's the board that makes the decision to both go forward with the financing and to go forward with the re-up. The board should be exercising fiduciary duties with respect to each of those transactions and under understanding what is the landscape, what if we walk away from this deal, how bad is it, etc. I mean, the times when I think that founder re-ups make sense is where you have maybe a couple of founders who have been involved, so they didn't have as big of a percentage to start with.

We've gone through multiple rounds of funding. They're still showing up kicking butt every day, but they're fully vested and their percentage is now creeped down to less than 10%. All right. So they're at 7% at each year five. They're not getting any more equity and they're in low single digits or in they're in single digits. Why not? I did this, I think twice in my career where I just said, I came up with my own standard because I said, listen, I think that this is a reasonable request. Five years, five points. Now I can go to all the investors, if they ever say, I say, I took this founder and got them to commit for five years. Okay, yeah, sure, that's $5 million,

is a $100 million company, but they have to stay. Five times 12 is 60. They've got to stay for 60 months. So they're getting, you know, essentially, whatever it is, eight basis points a month. We got them. It's hard to leave when you're getting that kind of compensation every month. And I said, no cliff, just monthly from the start. And it worked both times.

It was a reasonable request both times. But I added the fifth year to kind of make it more palatable to the other investors and board members. I don't know. What do you think of my innovation? Rate my innovation. Sound reasonable? I think it's reasonable.

I think four years would have been totally fine. But again, it's the concept of if these are the people that are really leading the company, still leading the company. And they've just been diluted down so much because of all of the rounds. And they're fully vested. That's the situation where you want to say, hey, we need to make sure these people are still motivated. We want to make sure that they're not going to go and look for the next best thing. that you re-up them. You give them a little extra to keep them involved.

Let's take on another issue, which is people start as an LLC. Yes, that happens often. Yeah. A partnership, a limited liability corporation, which is a partnership. Is that right? They're different. There's limited partnerships and then there's limited liability companies. Limited partnerships we rarely see, luckily.

Like, that's usually on the fun side of things. Most times when people set up a company, if they don't do it as a corporation, they do it as an LLC. I'm actually working on one where they set up their LLC in Montana. Wow. Montana law. Montana law. I think I know what that's about. Is that about the multi-generational trust thing or they just happened to be in Montana?

They just happened in me. It was Kanye, wasn't it? I cannot say. I cannot say. But Kanye came and he incorporated 42 companies because he had 42 great ideas last week. That's like a very Kanye thing to do is to go on like a legal website and just start 42 companies, you know, in one evening. He goes on a startup bender. He just incorporates 42 entities.

And then he brings it to Becky. Here, Becky, make sense of these documents. Help me. Help me. No. So, yeah, so starting as an LLC. there's there's nothing terribly wrong about that other than if you're going to get if you're going to look for institutional money VC money you're going to have to switch over to a corporation

and the cost of doing that grows the more that you do in the LLC if you create the LLC and literally all you've done is created the LLC and you you haven't done anything else you haven't brought in any investments. You don't have any other people that you've given equity in that LLC. It's probably not going to be that big of a deal to flip it. But most LLCs that we end up having to do the conversion into a corp four is messy. There's tax issues that go along with that. You're talking about two different types of animals. Like you're talking about an LLC that is a pass-through tax treatment. We've talked about this on another one of our. So go look at that. Go look at that. When you flip that into a corporation that does get taxed at the corporate level, there's issues.

What types of deductions have those individuals taken? So you as a founder in the LLC can get hit with a tax issue when you flip to the corp. You also have to just go through the process. Like LLCs typically don't have like stock options. So a lot of times people like, oh yeah, I gave my consultant a stock option, the LLC. Well, might not have because they don't really work that way. You actually kind of gave them a promise and a handshake of something that cannot exist in an LLC because those are units. Exactly. Exactly.

You can't give partnership units, but they can be revoked. I mean, it's just, it's a whole different entity. It's a whole different ballgame. And it will cost more money to get it over to a court. But it's not just legal. It's tax. And this is another thing. You know, when founders come to us about this, you know, the first thing I ask is like, okay, we're going to need to talk with your, you know, you should get your company accountant involved. Oh, we don't have one. Okay. You're going to have to get one. And you're going to have to get one now that understands all the issues that come up of flipping an LLC to a court. So you may have delayed on a legal aspect, but you're going to make up for both illegal tax and accounting. All right. We're going to do a part two. You can go to

this week in startup slash basics and you'll see part two of common first time founder mistakes with Becky from Wilson Sincini. Stay tuned.