This Week in Startups - Startup taxes deep dive with Scott Orn | Kruze Consulting Startup Finance Basics

Episode Date: January 29, 2021

Check out Kruze Consulting: https://kruzeconsulting.com/twist FOLLOW Scott: https://twitter.com/scottorn FOLLOW Jason: https://linktr.ee/calacanis

Hey, welcome back at Startup Basics. You know what we do here at Startup Basics. We try to give you the advice, the knowledge, the detail work that you're going to have to do for your startup. We've asked a bunch of our partners as one of the most active investors in Silicon Valley. We asked some of our partners, Wilson Sincini, Cruz Consulting, to help us explain these basic issues. And the reason I'm doing this, quite honestly, is very selfish. I want to have videos I can point to so that when founders ask me questions, I can say, just go watch this video. And one of the things I'm I am getting absolutely crushed by, and Scott Orne is with us here. He's from Cruise Consulting. You can go to cruis consulting.com slash twist, and they're available to talk to you. They do a great job. They work with a number of our customers, a number of our investments, superhuman calm, density among those. One of the things I'm getting is a lot of questions about the PPP grants that people got over the last year and related to taxes. Tell us a bit about why this issue is such an acute issue right now.

Yeah, thanks, Jason. So on PPP, I mean, if we all kind of transport ourselves back to March of 2020, it was a pretty scary time in the startup ecosystem. Like money had been flowing. Things were going well. All of a sudden, like someone grabbed the emergency break and the car skidded to a stop. And I'll never forget. Like, it was such a scary time for a lot of founders.

There's so many founders who were about to raise money, but hadn't quite gone out. Then you had the founders who had just closed around who were just like happy as can be. And so the government, in a response, to COVID and the unemployment and the economic hardship rolled out a program that I know it's taken a lot of fire, but I actually think it was pretty good. And what they basically did was give businesses, not just startups, but all businesses in the United States, access to extra capital in the form of PPP. And essentially, it was a loan that you could take. And as long as you maintained your employment levels and didn't cut people's salaries, but I think it was more than 20%, something like that,

you could actually get that PPP loan forgiven. And so fast forward to now, we have a lot of companies who took those loans and are now applying for forgiveness. And so that actually, it was incredibly stressful at the time. There wasn't a lot of guidance. The banks were scrambling. The accountants were scrambling. But I think it was a pretty effective policy, especially for the startup world, because

I think a lot of people's first kind of thought at that moment is cut, let people go, extend your runway because there's so much uncertainty. That was my advice. What PPP did was it, yeah, yeah. But PPP incentivized you to keep people on, essentially made those people, you know, free to work at the company for a couple months. And once we got through that shock,

a lot of companies were really glad they didn't let people go. They were able to kind of maintain the speed they had gone through. And I think that's one of the reasons things have bounced back so fast. Now, the other thing that happened is very recently, PPP2 was launched. And PPP2 is another round of this like stimulus funding for businesses, but the caveats are a little tighter.

You must have gone through a reduction of 25% in gross receipts in one of the quarters in 2020 compared to 2029. So 2028. So you can't be going gangbusters. Revenue must have gone down. So they put a couple of more conditions on the paycheck protection program

is what PPP stands for for those people who don't know. And this second draw of PPP loans, I think they even said the revenue or the number of employees of the company has gone down as well, because that was the big crazy criticism was like some people had,

I don't know if a shake shack or somebody had taken money. And it was like, this is a public company with whatever hundreds of millions of dollars in the bank. Why are they taking this? It makes no sense. Or Harvard famously, I think,

got some grant and they were like, Harvard's got a $40 billion endowment. Why are they doing this? And so people... The L.A. Lakers took a bunch of money, you know? The Lakers took money. Yeah. Yeah. Yeah. So, but you're right. And so there had to be like significant harm to the business. And

basically what you get is two and a half times your average monthly salaries or gross wages that you paid in 2020. So it's a pretty big boost of cash for companies. The other thing that I think a lot of startups, you know, are taking advantage of they a lot of, there was a lot of kind of like, stress and pressure around the first time to not take money from people. And I totally understand the logic. The logic was, especially for mid to late stage startups, I agree with this. Like if you have a big venture capital fund behind you, maybe the government shouldn't be giving you money, right, kind of thing.

Right. So there's a lot of companies that kind of sat that out. And what we're seeing this time is those companies who didn't draw the first time, but were eligible, are coming back in PPP2 and saying, you know what? Like we did suffer. You have to, you have to do a rep and warranty that you suffered through COVID. But we can tap this money and maintain our employment and actually help the company a little bit. So we're seeing a lot of, it's called a first draw at PPP is what is happening right now.

So there's two sets of companies getting money. The ones who are just crushed by PPP, they get like kind of a second dip. And then the first, the other group is people who didn't take money last time, but were eligible and are doing it right now. Yeah. And we saw something happen in our portfolio, which was the CEOs had to. sign off on this, right? And this is a key moment of truth because they would bring it to the boards and the boards would say, okay, well, what do our service providers say? What does Cruz say? What does Wilson Sincini say? What does this law firm say? What does this accounting firm say? And, you know,

they said, like, very reasonable. This is the first time we've ever gone through this. So there's a lot of things we don't know. But you are certifying this and it could be read, you know, whatever way. And to the credit to the the Trump administration that did this, it was very helpful. It's, there's no way to do it perfectly. But I had one or two founders who, to your point about raising money right before, they had raised money. So they were sitting on $5 million in, I'm just making a case here. They're sitting on $5 million in their bank account.

And then they're applying for $400K and PPP or whatever. It didn't make any sense. And a bunch of them who had filed for it and had gotten it just declined to take it, which I thought was kind of cool. like it wasn't meant to be free money. It was meant to keep people on their jobs. And, you know, we were considering laying a bunch of people off. And it was like, okay, PPP's here.

Great. We'll keep people around for a little bit longer and see what happens. It was, you know, what I heard from a lot of the companies that were affected. So it does seem to be a really, really great program. But let's open the aperture of this discussion and talk about just taxes in general and how to think about taxes in terms of a startup. Most startups are losing money. So does that mean?

they're not paying any taxes. It's a great question. I get that question at least once a day. So you are losing money. You are not going to pay taxes in like kind of the way that the federal and state income tax. But you still need to file a tax return. This is like such a common thing. The government wants needs kind of proof and needs you to certify that you didn't make any money.

And they want to see the financials. They want to look every year and be able to go back and say like, oh, this is what they filed last year. So you still need to do a tax return. Super important. we've talked before in private conversations about having nexus in other states. If you have employees property or assets in other states, odds are you are triggering tax nexus in those states. And this has become super common with COVID with companies and their employees going all over. And so odds are you'll probably have to do a few more state tax filings this year.

It's not a huge deal because Cruz, we are a CPA firm. We do taxes for all of our clients. When we do the federal tax return, a lot of the state stuff is kind of like kicked out from the software. So it's not a huge amount of work. But there is a lot of work looking and seeing if your sales have generated tax taxes, even if you don't have employees in certain states. So there's a lot of stuff going on. Just always file a tax return. And if I may, try to work. This is a little self-serving, but like try to work with someone who is familiar with startups. one of the big mistakes, we see a lot of mistakes on tax returns. When you go through diligence, this is one of those areas where the VCs or the accounting firm,

they actually hire to do diligence, they're going to open your books and they're going to open the tax return. All those numbers need to match. If your numbers are not matching because you use a not so great tax firm and your balances are off three or four hundred thousand or three or four million dollars, you're going to have problems. That's going to tell them you need to restate something. So do that. And then the other thing I see is a lot of founders, like we always kind of joke that they go down like Camino Real and San Mateo and hire whatever CPA firm has a shingle outside, you know, their office kind of thing.

If you work with someone who knows startup taxes like us, they'll tell you that you can do an R&D tax credit. An R&D tax credit has been around for a very long time for many, many years. But you used to only be able to use it to shelter income once you are profitable, which meant that like companies didn't. And it wasn't super important companies because most startups don't get profitable for a very long time. And then if you are profitable, you probably don't need it. So it's like an after. Yeah. Or you got bought already, you know, yeah, Republic.

He has your exit. Yeah. But three years ago, the IRS and Treasury got together and said, like, you know what? Let's start letting R&D companies use this on their payroll taxes, which overnight made it an immediate ROI. And so last year we did $8.5 million of R&D tax taxes. I should probably do 20. So that means our companies got $8.5 million back last year that extended their runway, all because they filed an RD tax credit.

We filed it with their payroll provider, and they get a big rebate on their Social Security taxes. And so it's actually, like I've had, yeah, go ahead. Let me ask a basic question about that. If I have 10 developers and seven of them are working on the 1.0 of the project and three of them are working on the next version of 2.0, do I just take? those three and say, that's my R&D department? Or what if the 10 people are spending 30% of their time on the 2.0 and 70% on maintain the current product? How do you say that this is R&D

versus maintenance of an existing product? Because isn't a startup by definition 100% R&D in those first couple of years? Exactly, especially the ones that have no revenue. You're basically kind of de facto in R&D mode until you start generating revenue. And forgive me because I'm not a tax fee pay. My wife is. She's the brains behind this operation. We have a bunch of tax fuel. I believe it's something like five years after you start generating revenue is basically your eligibility time period. But your initial question about like, say you were generating revenue on the core product and you had seven of your engineers doing that. And then three of the other engineers were generating, we're doing future R&D. It's really only that

future R&D counts. And so when we do an R&D tax credit, we actually do an interview. with the management team and we actually look at the allocations of what people are spending time on. It's actually, I mean, it's pretty easy to- So you act like a third party auditing that in a way. Auditing is probably the wrong word, but, you know, you know, determining that in the same way a 409 might be done, you have some independent person saying, here's what I think's reasonable, and you have reputation risk and you're putting some skin on the line when you do that. So therefore, that helps the company navigate that, correct?

Totally. Well, even more, Jason, we not only have reputation risk, if Vanessa, my wife, who signs the tax returns and Lorena and Will, other people on our team, sign these tax returns and do it fraudulently or fraudulently do an already tax credit, we are in serious trouble. Like, I cannot have my wife losing her CPA license. Yeah. So, serious. This is what I'm kind of talking about, though. Like having that incentive as a CPA firm to actually do things right means the client actually gets better service and is protected. And if I can connect this, when you're doing your due diligence for taxed diligence during M&A or doing a round, like we are on those calls reppping all the tax diligence and the tax return and the R&D tax credit.

And if you're not getting like a 20 page document that documents the credit that you can hand to an auditor, something's wrong. Like we have had credits audited doing it's very similar to a 4NA. If you've done the documentation and you can present that to an auditor, it gives you. the auditor knows you planned ahead. They know you work with someone reputable. It's so much easier to pass the audit. And so there's just like these massive incentives. But your question about like how much can be, you know, how much goes to the credit?

It is a judgment call. We rely on allocations, rely on time cards, things like that. But just do it right. Don't kind of just short shortcut it because you can end up. It's not even just the IRS auditor. It's the financial auditor like at C. or series D. You know, when you're doing a big round,

you're going to start getting audited every year. They're going to go not, they look at stock options, look at the financials, and they look at things like R&D tax credits and your taxes. So just make sure it's all done correctly. When we say the nexus,

this means, is that a fancy word for you're doing business in that location? And let me throw a couple of curveballs here at you. And we'll see how you do on the fly here. Do I have a nexus in this? And I know it's different by state. So this is completely.

unfair. But am I correct that if I'm doing a trade show somewhere, then I am not like if I had a trade show at CES. I'm not Nexus in, I don't have a Nexus in Vegas. But if I open a store at the Bellagio stores to promote my new hardware product, I do have a Nexus. Correct? That's exactly correct. And if I can add something on top of that, it was online sales have gone through kind of and SaaS sales have gone through a change in nexus over the last probably three years there was a supreme court decision wayfar versus um i think it was north dakota i'll be so embarrassed if i got north dakota or south dakota wrong there but uh one of the dakotas said by the way they're both doing great at virus uh doing vaccines right now north kore and south of

have the most vaccines in arms on a percentage basis great job that's amazing really that's awesome They're doing great. So they said, like, hey, we want to be able to tax our citizens who are buying stuff from Wayfair. And Wayfair said, well, we don't have Nexus. We don't have anyone in that state. You'll probably remember, like, Amazon was really good at not setting up distribution hubs in certain high-tax states, right, back in the day.

And so the Supreme Court said, hey, we're going to change the law. And after you pass a certain threshold of revenue on citizens in that state, they can then be taxed. The number is somewhere around 50 to $1.5. 100K usually. But so that means that even if you don't have a shop in Nevada, but you're selling a lot of Nevada citizens and they're buying your SaaS software or your e-commerce stuff you're selling, you can actually have sales tax nexus in those states. So if I'm selling Slack and I get a $100,000 client in South Dakota or wherever it happens to be, I may have to pay tax on that now. Exactly. But for the first year, if you're selling $5,000, you might.

not. You're exactly right. And even today, that was like three years ago, even today, a lot of states are not charging like SaaS sales tax and things like that. But we all know like the state budgets are always a mess and the states are always looking for more revenue. So this is kind of a steady march that I probably in another two or three years, I'd expect every single state to be charging sales tax and things like that on SaaS. There is some good software out there like Avalara or tax jar, which can help you manage that. So in the same way that QuickBooks manage, your accounting infrastructure, Avalar or a tax jar will help you manage your sales tax infrastructure and make it a lot easier. It's something we interact with tons.

Yeah, and I just pulled it up here. It was South Dakota versus Wayfarer 2018. United States Supreme Court Rule 5-4 in South Dakota versus Wayfar that states can mandate that businesses without a physical presence in the state with more than 200 transactions or, not end, or 100,000 in-state sales collect and remit sales taxes on transactions in the state. So 200 transactions for a $10 product is only $2,000. That could be, you know, a bunch of paperwork, et cetera. And so you want to get that right. And it is complicated, but business is complicated.

Our tax law in the United States is complicated. And you're not going to change that. And there's no way to route around it. You just got to suck it up and do it right. And taxes, whether it's the payroll taxes or your sales taxes or franchise tax, which I never really even understood what franchise tax was as a concept. Does that mean a franchise isn't like a franchise like a Chucky Cheese franchise or whatever? It just means an office or a business in a state.

Is that what franchise means? Like a going concern? I actually don't know. But I don't know. But one, if I can just save some founders out there, some embarrassment, we've had companies come to us for a lot of founders don't get kind of confused about why Delaware. Why are people registering in Delaware, corporating in Delaware? it's because the case law is well understood and Delaware is a business-friendly state.

And so venture capitalists only really want to invest in Delaware C-Corp. They don't want to invest in LLCs or S-Corps because those are pastor entities and mess up your fund taxes. And so everyone that you're investing in is probably a Delaware C corporation. You have to pay franchise tax every year to Delaware. It's a small amount, especially for C-C. A couple hundred bucks. Yeah. It's very cheap. Like 400 usually is like a C-Stage.

company. If you don't do that, you can forfeit your corporate entity and forfeit the corporate liability shield that you have. And so we've talked about embarrassing things. I'll never forget one, one, probably two or three years ago, one client talked, or prospective client, talked to my wife. He was like, oh, this is, this is too complicated. It's too expensive. I'm not going to sign up with Cruz to do my accounting and taxes. Two weeks later, he had a term sheet from a super pristine Sandhill Road company. They had given the term sheet. They had then done a simple Delaware search, found out he had not paid his

Delaware taxes in two years, forfeited his entity. And they called them. And they're like, what's going on here? And it was like the guy just like shot himself in the foot. And that's kind of like, that's not the worst thing. The worst thing would be not to do it and then get sued. Right. And the person who's suing you can come.

after you personally. Yeah, it would be the equivalent of like you're a truck driver and you let your license expire. Like you're supposed to have a higher level of duty and care as a founder of a company. You're not just a civilian driving a car and oh my God, I didn't realize my license was, you know, wasn't renewed. Okay, the cop may give you a warning. This is like being a truck driving. You're driving a semi down the road. There's a bunch of people involved in it. There's customers. There's employees. You can't not have your paperwork for your 18 wheel rig, you know, not right. You have to have your insurance papers and you have to have your license and everything and your registration. Can't support that. In California, it's like sometimes we have

folks who think they're kind of going to get around it and they think that like California doesn't know you're operating here. But then the address on the tax return, is a California address. And somewhere in the bowels of the IRS and California franchise tax, there's social security numbers that match up. And so routinely, like two years later, there's a two or three, $4,000 debit from someone's bank account because they didn't file California franchise taxes a couple years ago.

It's just like you said this many times in this conversation. Like, just do it right. It's actually pretty easy to do it right. and you won't have these like little nasty surprises that throw you out the rhythm of your day and you can actually build your company. It is one of the things that you can be sure of. You will, if you don't do this right, get a phone call because as you pointed out, Scott, very correctly, the states and the cities and all these different geos are, these geographic,

you know, regions are dependent on this revenue. This is their income and revenue. This is how they pay for sanitation workers and teachers and fixing potholes. This to them is their revenue source. If you had a customer who didn't pay you, you would send them to collections or you'd call them up and say, hey, we need to get paid. That's what's happening here. So you just have to take it as part of the cost of doing business is that you have to pay

your taxes. It's a bummer for everybody to write these checks sometimes or do all this work. It's not work on your product or with your customers or marketing, whatever you like to do, some off-site retreat with your team. But you've got to dedicate, you know, a couple of days a month to making sure all this is tight. And tight is right. Make it tight. Man, I can tell you, since when I was in my 20s and 30s and had magazines, I was always

behind, always filing extensions. Now, super buttoned up. Always super buttoned up. I always tell people top priority. I want everybody to get their paperwork on time. I want it right. I want to spend the money and do it right because I want to sleep well at night, not getting certified letters or scary, you know, franchise tax boards or all this kind of stuff. And you

will get those letters. And you've said this before in our discussions. Getting on the phone with the IRS and fixing this stuff, I mean, it could take months. And now you've got to deal that's closing in days and you've got to go get your franchise board stuff worked out. That's that, what is that going to take? Two months, three months to get it fixed and get a new piece of paperwork. There's, there's no expediting this stuff, right? No expediting. And your friendly accounting firm hates doing that too. Like there's there's nothing more like it just bums you out. You're like a high qualified accountant or finance person and you're sitting on the phone like

waiting for the IRS to pick. It's just depressing all the way around. So yeah, just do it right. The one I would we actually have we did a little bit of homework for everyone. We actually have a startup tax compliance deadline web pages for every major market for startups. So you can just Google like San Francisco cruise tax deadline. or Austin or whatever, you'll get a list that's itemized.

And I've found over the years that that actually kind of takes a little bit of stress out because once you can kind of visualize the things you need to do, it's really less stressful for everyone. And there's even links to like filing an extension and things like that on those pages. All right. Listen, this has been great. Go to cruis consulting.com slash twist. They're our partner. They work with all of our companies.

They do a great job. Scott, really appreciate your partnering with us on this. We're doing four or five of these. we're going to try to just take every single difficult discussion and just Scott and I, we're going to hash it out and try to make it easier for you to not be scared or nervous about this. Just do it right and you'll be fine. It's kind of like when you're driving. You stay in the lane, you go the speed limit, you park your car in a proper spot, you don't put two tires on the curb, you don't go 90 miles an hour or in a 65.

Just pace and do it right. That's the message here. Do it right. Have a good partner like Cruz. Like anything else, you do it buttoned up and you will have less problems down the road. If you cut corners, they could turn into giant landmines later. Giant landmines. So don't self-sabbit.

I think people who do this, you know, it's my secret theory, Scott, people who don't pay their bills like tax things and don't do it right. I think they're self-sabotaging. I don't think they want to be successful in life. So they take these things that are important. You see this, right? And this personality type who like doesn't do their legal stuff. They don't have people sign IP assignments. they just, they're self-sabotagers.

And don't do that to yourself. Why go to work every day for 12 hours, try to change the world, and then literally take a gun and point it at your foot and fire it. It's literally what you're doing if you don't file your taxes on time and have these books correct. I totally agree. You fire your customers if they're too self-sabotaging? What do you do when you have like a total disaster of a client who moved doing life?

We've had to, we, I mean, we got in this game the same reason you did. We love founders. We've worked with found, like my wife's a founder. I'm the third employee at Cruz. So we have a, we have a very high threshold of tolerance. And we kind of look at ourselves as like the coach or your, your gym trainer or things like that. So like we're, we get a lot of satisfaction out of helping people and turning them around

and getting everything cleaned up. But they're very rarely, but once maybe every six months, there's a client who just like can't get their act together. And we're CPA firm. So we become liable if your taxes are. wrong or the financials are wrong. And so a tax return, you know, there's all this like, it actually is hard to sleep sometimes. And so, um, so we do end up having to let people go. Again, it's very rare. We don't enjoy that. That's not fun. That's not why we're in the game.

But we have like, we have to kind of for the 99% that play the game right and do their homework and do things correctly, we can't, we can't be spending 20% of our energy on the 1% who just refuses to kind of get the ball game. I've had to do it with people in my portfolio. I've had two or three times where I've told people who I'm on their cap table, I think you'd be better off with a different investor. Would you like to buy my shares back or I can find somebody or whatever we want to do? But we have to unravel this because you have to behave in a professional manner. That's always what I tell you.

You got to win, lose, or draw doesn't matter. Playing the game right is what matters. So just play the game right and the outcome will take care of itself. Whether this company fails and you succeed on the next one, You look at superhuman. We both have Raoul as just an amazing inspiration for us. I was in the first company, reportive. I think we made three times our money.

It was modest return, four times, whatever. It was three or four X. It was nice, but I wish he had gone long, you know. They did a quick sale to LinkedIn. You know, he had partners or whatever. He tells the story very publicly. But I was playing for the next company he did, which was superhuman. And we wound up being one of the first two checks when he was just an idea on a piece of paper.

And it doesn't matter to you. me that, you know, a company goes to zero. We had go walla, the last guy to now go walla again with my friend Josh Williams. And we've invested in him three times. So people don't mind you losing, but they don't want you to play the game incorrectly. That's the message you're getting here. Do it right. Keep it tight. Tight is right. Period. I totally agree. I still remember sitting in the commerce room when Raul and Vivek came over. First of all, I was a report of user and I loved report of so I was so bummed that got sold to LinkedIn. But I actually both of them said like, hey, our financial infrastructure last time was because Vivek had started

a company too, was a little disorganized and not what we wanted. Loosey goosey. And so that's, yeah. So they came. And also founders need to know like you can be two people and an idea and a little bit of money and get professional help. Like that's when I think calm was probably five or six people and Superman was the Vak and Raul and you know, Andrew was a little bit later stage. But like, yeah, get it set up early and then it's super easy to maintain it. Yeah. All right.

Listen, this has been great. Everybody go to cruise consulting.com slash twist. If you want more information, they do a great job. I personally can tell you they've done a great job for our companies. I'm sure they'll do a great job for you. We see you all next time on startup basics.