This Week in Startups - The Top 6 Startup Finance FAQ’s | Startup Finance Basics w/ Kruze's Scott Orn

Episode Date: December 12, 2024

Todays show: In the latest edition of Startup Finance Basics, Jason sits down with Scott Orn from Kruze Consulting to answer the six most important founder/startup questions around finance, accounting, and taxes. * Timestamps: (0:00) Kruze COO, Scott Orn, joins Jason to dive into Finance Basics FAQs. (1:05) How can I avoid paying payroll tax as a startup founder? (6:54) How do you shut down a startup? (11:33) Why do I owe Delaware $50,000 in franchise taxes? (12:58) I’ve got my first customer lined up! How do I get paid? (16:26) Can I tell VCs that implementation revenue is ARR? (19:59) Should I raise venture debt when I raise my Series A? * Check out Kruze: https://kruzeconsulting.com Check out more Finance Basics here: THISWEEKINSTARTUPS.COM/basics * Subscribe to the TWiST500 newsletter: https://ticker.thisweekinstartups.com Check out the TWIST500: https://www.twist500.com * Subscribe to This Week in Startups on Apple: https://rb.gy/v19fcp * Follow Scott: LinkedIn: https://www.linkedin.com/in/scottorn X: https://twitter.com/scottorn * Follow Jason: X: https://twitter.com/Jason LinkedIn: https://www.linkedin.com/in/jasoncalacanis * Great TWIST interviews: Will Guidara, Eoghan McCabe, Steve Huffman, Brian Chesky, Bob Moesta, Aaron Levie, Sophia Amoruso, Reid Hoffman, Frank Slootman, Billy McFarland * Check out Jason’s suite of newsletters: https://substack.com/@calacanis * Follow TWiST: Twitter: https://twitter.com/TWiStartups YouTube: https://www.youtube.com/thisweekin Instagram: https://www.instagram.com/thisweekinstartups TikTok: https://www.tiktok.com/@thisweekinstartups Substack: https://twistartups.substack.com * Subscribe to the Founder University Podcast: https://www.youtube.com/@founderuniversity1916

Hey, everybody, welcome back to This Week in Startups. We're doing our Startup Basics. It's a very simple series. You can go to This Weekend Startups.com slash basics to see all the different episodes we've done. This is where we work with some of our top partners, service providers, accountants, legal, and HR talent to help you. Founders make sure you're doing things right. And tight is right with me again. My pal, Scott Orne, he's the CEO over at Cruise Consulting with a K. They're a CPA. They focus on VC-backed startups. They've got tons of our portfolio companies as clients, including podcast AI. They're doing great. They have revenue. They raise money. And then a couple of our, you know, legendary startups like Superhuman and Com started with Cruz and then graduated

because, hey, they became really big companies and Cruz likes to work with the emerging ones. How you doing, Scott? I'm doing great. Thanks for having me. All right. Let's talk about some of the most common founder startup questions we do. get, the first one we should do is, how can I avoid paying payroll tax as a startup founder? I think it's going to be an amazing episode because you and I, like, we're teed up on these. We hear these same kind of crazy stuff. So you probably are not going to be able to avoid paying payroll taxes as a founder. But I can't tell you, I'd say once a week. I get this question, Jason. It's completely insane. And if you're a founder out there, first of all, you should be

focusing on building your company, not trying to avoid taxes. The upside. for building an awesome company is way higher than avoiding payroll taxes. And second of all, the IRS is pretty much thought of everything. So there's a couple of ways you can reduce your payroll taxes, which will cover. But just kind of get it in your head that you're probably going to be paying payroll taxes. And one of the common ways that founders think they can avoid this is they decide they're going to be contractors to their own company. And that's a no-no. The IRS will look at this and say, like, wait a second, Bob or Mary, you own.

35% of this company on the cap table, and you're saying you're a contractor, that doesn't make sense. That makes me, as an IRS agent, think you are trying to avoid paying payroll taxes, and that's a really good way to get a letter from the IRS and get a bunch of penalties assessed you. This concept that everybody's going to be 1099, you're just going to give them cash, is always a mistake. I've got to tell you, half the time you do this, you will wind up having somebody claim that they thought you were withholding their taxes and then they want you to pay them. And by the way,

in some jurisdictions, man, I have been up against it in some jurisdictions with different companies and they'll just be like literally in one case, the tax board just said, listen, you're a rich company. I just Googled you. You raised 20 million. Just pay the taxes for this person. They literally said that. And I was like, I went to the lawyers. I was like, wait a second, employment lawyers. We did everything right. And they were like, yep. I'm like, how much is it going to cost to fight this? And they're like, you'll win if you fight. it's going to cost $30,000, maybe $50, depending on how many times we go back and forth. I'm like, well, what are they asking us to pay? They're like $8,000. I'm like, so we pay the

eight, even though we're in the right. Yep. So even if you're right, the cost of, you know, dealing with this is just incredibly high. The reason the government, correct me if I'm wrong here, Scott, wants people to pay their taxes and not do this 1099 stuff is if you were allowed to do this, everybody would do it. It's everyone needs, and by the way, the solution is so simple. Just sign up with a payroll company. There's so many good payroll companies nowadays. They will automatically take the payroll taxes out of your check, your employees' checks,

and they will send that into the government. You never have to touch it. In the old old days, CPA accountants used to send that in themselves. No, no, no, not anymore. The payroll companies automate this. So it's really going to be literally as easy as you might think, or as easy as avoiding or trying to scam and avoid it, just do it the right way. By the way, Jason, the other thing is when you get an audit from the IRS on payroll taxes,

they give you the choice. They say, you can challenge this if you want, but if you challenge this, we're going to look at every single payroll record you have done over like the last five years. And that is signing out. That could be disastrous for your company. So you really want to just, you know, move on, pay that fine if you're getting a fine, and then sign up for a payroll company. What are the circumstances where you hire a freelance designer,

who has a company, they're going to work for you for over six weeks to do a 50-hour project. Would that be okay to just pay their LLC? They send you an invoice, you pay them, and you don't withhold the taxes? Yes, as long as it's armed length transaction,

and it's not, there's a, you know, you probably know this better than anybody. Uber had this whole battle with the state of California, a lot of startups are in California. So California itself is aggressively on the side of the employee or the contractor.

And so there's a pretty high bar where you have to be able to show that like they're working in their own hours. They have their own company. They're using their own equipment, all those kind of things. So if someone's got a web development agency or something like that, that's going to be fine. They're going to invoice you on their paper, meaning like web agency.com or whatever is going to send the invoice. That's fine. It's when you are hiring someone who's only working for you and they're working 40 hours and you are telling them when they show up, all that kind of stuff. that means they're not really a contractor.

They're more like an employee. So just be really, really careful. They used to be like a test where you can go down this test. And what people need to understand is like a lot of those tests that you see online are not actually legal tests. They're guidelines. And so you need to work with a professional if you're going to do anything close to the line. And my perception is this is very much state-based in addition to federally based. and there's interpretation, and if you're anywhere near the line,

you might as well just withhold tax, unless your entire business is predicated on this, like Uber and Lyft and DoorDashes, in which case they have unlimited resources and in House counsel to negotiate and lobbyists. I mean, that's the level it got to with an Uber, a lift, and DoorDash. They literally had lobbyists making sure,

and I'll be honest, the employment situation here in the United States is kind of binary. You're either full-time, or you're a contractor, and there should be something in the middle. There should be like a contractor that if they hit a certain number of hours a year, let's say a thousand, you know, which would be half time. You know, something happens where they contribute some amount to your taxes,

some amount to your health care, whatever. Anyway, we could debate all this what we think is right. Just do what's right in your state. And man, I got to tell you, these payroll companies are very sophisticated. Yeah. And so, you know, use a payroll. company and have experts. All right, this is the time of year. Also, when a lot of founders start thinking about shutting their company down, Scott. What's the process for officially shutting down a

company? And how long does it take and what does it cost typically to do this? Yeah, it can take a month of three months. And I think the key thing is, if you're a founder, you want to live to find another day. You want to make sure that your investors know you tried everything, which includes trying to sell the company, trying to find a home for not just the team, but the technology, and kind of exhausting that. If they just think you just walked in one day and decided to quit, you're very unlikely to get a check from them again on your next company. And odds are, when you start another company, those investors are going to do diligence with your previous company investors. And so you want to just make sure everything's above board, just like

from a relationship perspective. And, you know, transparency goes a long way. Hey, we tried. It didn't work out. Here's a little narrative of what we tried and why we think it didn't work out. We really appreciate everybody. Here's when you're going to get to take the loss. You know, we're wrapping things up in 2024, but you'll be officially taking the loss in 2025, just for tax planning, especially if somebody put a lot of money in. They could know that. And yeah, we're selling all the laptops. We're selling all the equipment. We're selling the domain name. And whatever's left, we'll go to shareholders. There's a million dollar convertible note at the end. We expect if we sell everything, it'll be 100K,

that 100K will go to the people who are the last note holders. You were in the seed round. You're not part of the last group of people. If there's any money, they get it first, so you can expect that nothing's going to be trickling down to the seed round. Boom. That's exactly it.

And you know what? We're adults. We've been through this. We expect 80%, 50%, you know, depending on what stage you're in, to go to zero. So when something goes to zero, it frees you up to do your next company and pitch us on that,

and maybe we go on the next adventure with you. Yep. And you do have to remember do your final tax return and also do a final Delaware franchise tax and let Delaware know you're shutting the company off. You don't want to keep get like state of California or state of Delaware. Someone, one of these states do think you're still operating because eventually by two years from now, they will start auto debuting your personal bank account. They're very good at figuring out what banking institution is working with you as a founder and your personal money. And so it happens sometimes. So just make sure you. you shut it down correctly.

It's really, really easy to do. We have a blog post on it. It tells you exactly what to do. There's also firms that just do this now. And then if there's one other thing, Jason, make sure you have enough cash to pay your PTO before you shut this company down. PTO is paid time off for employees.

That's the one thing directors and officers are personally liable for. If you think you can stiff your employees on PTO, you are very, very wrong. you're going to end up with a bunch of liability. And venture capitalists know this. And usually the first question they will ask you after you tell them you're running out of money is, where are we on PTO? So come to that meeting, know exactly how much money you owe for PTO, because that's going to be a major decision maker.

This is why some people like to award days at the beginning of the year as opposed to having people accrue them. It's a little technical, but people can either get, you know, 1.2 vacation days a month for every month of service. That's accrued. That means you earned it. that means it has to be paid out if you shut the company down or the person leaves, they get that. They earned it. If it's awarded, you get 17 days a year, including your floating holidays, sick days,

personal days, vacation days, whatever it is. The person could take them in the first three months, leave the company and then you're like, oh, that was a bummer. They took three weeks off and they left the company. And you know what? There are angle shooters who do this kind of nonsense. I see it all the time, and I'm like, oh, God, wow, you got me for two weeks of vacation and then quit. I mean, who cares? At the end of the day, career-wise, it doesn't matter to me or for the companies. But that's why some people do the award the days, yeah, so they don't build up this liability on their books. Yep, exactly.

And one other thing I'd add is that there's a lot of people who've come on this adventure with you, not the capital providers, but the employees. And so there's a lot of people with young families or mortgages or whatever it is. So helping the company get sold so that they can find a place to work, even if it's for three months, six months, whatever it is, that really goes a long way for a long way for a lot of your employees. And the odds are you're going to probably start a company again. I see it constantly. Like we're the second time around, third time around. And those are usually even bigger successes because the founder learned a bunch on the first turn. You can burn the

boats, but you can't burn your team and investors. Very simple way to think about it. Number three, why do I owe Delaware 50,000 in franchise taxes? This comes up sometimes. What's that about? Oh my God. So I get like five screaming emails every year from people who aren't working with us. We're trying to do it themselves. And there's a very, it's a little complicated, but Delaware has a couple different ways of calculating the franchise tax. And of course, they defaults you when you log into their website to the most expensive, meaning the most lucrative for them.

And all it takes is for you to know your share count and your total assets. And you can punch those into the website, hit recalculate, and it'll go down from 50K or 140K or wherever the crazy number is down to 600 bucks or $600 or $3,000. But this literally gives people heart attacks. They think they're going out of business. So, you know, we have a blog post. We have a video on this. Please be calm.

If you see that big number. And also, by the way, sometimes there's a law firm associate who doesn't know this trick and sends you the email saying you $120,000. And they just don't know better because this is their first year on the job. They just graduated law school. So even if your law firm does this, take a breath, look for our blog post. or video, whatever you want to do, just remember to enter those two pieces of data in the Delaware franchise tax payment portal, hit recalculate, give it a second because it's very slow,

and you will be amazed that you just save $50,000. There you go. All right. Question number four, we get this one a lot. Hey, I just sold a customer. I told them to be $50,000 to use our software for a year. It's going to be $5,000 a month. I'm going to give them a discount.

They negotiated me down to $50. What do I do now? Yes, this is a good one. This is a happy moment. Yes. So the first thing is you need to see if you actually had them sign a contract. Ideally, you have. The great thing about the law firms in Silicon Valley, I know you work with Wilson Sassini and they do startup basics too. And Fenwick and Goodwin, but Wilson Sincini does do startup basics with us. Yes. So they will actually give you some very kind of templatized documents,

including some type of customer contract. And so you can just use that out of the gate. It doesn't have to be super fancy. Get the customer to sign that. Obviously, you want to make sure that you're locked and loaded on that. And then the next thing you do after that is you're going to invoice the customer. And ideally, I always kind of preach to startups, the cheapest form of capital is the capital that your customers are giving you. So the more bootstrap you can do, the better. I always encourage startups to collect as much of it up front as possible because that just helps you out. Send that invoice, give them 30 days to pay it. Ideally, you'll negotiate that prepayment. And once you get that cash in, you're going to do some fancy accounting. Some of that's

going to be deferred revenue. The part that you can recognize up front is the part where you've already been providing the service. So say you invoice them, it takes them a month or two to pay you. You've been providing that service for two months. You get to recognize two months out of maybe the 12 months in your profit and loss statement. Does that make sense? Totally. And one of the things I always encourage founders to do is if you're giving a discount, then you have the high ground. Hey, I'm going to give you this two months free, but you got to pay for the year up front. front and then you have to have cancellation terms. If you cancel, you know, you, we need 90 days notice. So if they cancel in month three, then, you know, they stop paying in month seven and

you know, you have time to offboard them and whatever expense you put into it. You're golden. And big companies, they're used to this kind of thing. They'll deal with it. Sometimes they're CFO or accounting department will call you and try to grind you. And you say, well, no, when I talk to them, I gave them a discount. Oh, well, it's not our policy. And you say, yeah, but I gave them a discount. So if that's not your policy, our policy is you got to pay 60K, 5K a month. If you want the discount, we need the 50K, and they'll make their own decision as to what they want. You can use any number of platforms, stripe, quickbooks, you know, there's bill-paying platforms everywhere, just like there are HR platforms everywhere. People should know, they should know,

accrual versus cash-based accounting. VCs want accrual-based accounting because it gives the truest picture of the business, but angel investors and early stage investors like myself, we do like to know the cash. So maybe tell us about, you know, as quickly as possible, accrual versus cash-based. Yeah. Say you get that prepayment and they're going to write you a million dollar check, hallelujah, up front. Cash accounting would be booking that entire $1 million as revenue on day one. Accrual accounting would be booking that million dollars over, let's say it's a 12-month time period. providing that service. You do one-twelfth of that every month. That way you're booking something like, I think, $85,000 or something like my mask is not perfect on this, but $85,000 a month over 12 months.

Does that make sense? Totally makes perfect sense. All right, we are cruising through these frequently asked questions. So can I tell VCs that implementation revenue is ARR? So implementation revenue is ARR. Every week, probably. Well, and to use like a less fancy word than implementation, consulting revenue. Highlet revenue. Yep. Pilot revenue. Is that a good idea?

No, that is not a good idea because you, two things, you're misrepresenting what your forward-looking financials are going to be because it's not accurate. You should only, I suppose you for SaaS companies or AI companies, you want to represent like the monthly recurring line item. If you have implementation or pilot revenue, something like that, that's, Great. That shows that people are drawing out, their dog fooding the product. Just put it in a second line so that it's very obvious to investors. When you go through this process of raising money, your most important asset is your credibility. And anytime you're playing,

hide the ball or loading things into your revenue that's not really, shouldn't be there for ARR, you're actually going to hurt your credibility because people like you have seen this movie a thousand times, 10,000 times maybe, right? I mean, people don't understand this. but if you are making false representations, false would be knowingly or inaccurately because of your own stupidity or thought, or you're just not tight, either of those combined with selling securities,

there's an interesting word for this, securities fraud. You may not think you're committing securities fraud. You may think that somebody trading shares in a company with inside information because their cousin works at Netflix. Okay, that's inside of it. trading. When you're selling a security, it means your private company sold some shares to

Y Combinator, to launch Accelerated Techstars, or to an angel. If something in that deck is not quite quite right and it's material, you don't really have a leg to stand on. That person can just say to you, I'll take my money back where I'm going to sue you. I'll give you an example. Somebody in our portfolio, we got a complaint from somebody who had put 50K in. The company was going out of business, and they went back to the deck and there were things in it that they said that weren't true. One of them was that this person

was on the team. That person was not on the team. Wow. This really savvy angel investor said, you lied to me during the fundraising process. I'm about to send this to the SEC for securities fraud unless you send me my $50,000

back right now. I will give you till the end of the day. Founder, scared to death, sent the money. That was the only investor who got any money on the company. And they just found this. little piece of information.

And I was like, well, that's pretty freaking savvy, isn't it? But the truth is, like, if the company had been successful, they wouldn't have done it. You just gave an option to somebody to get their money back. And none of us expect perfection anyway. Yeah. So if you got $100,000 to build somebody's website and then their website linked to your SaaS product, but they wanted you to build the website as well, and that kept the lights on, we understand.

Keep the lights on ourselves. I, listen, I'm here doing podcasts. know, it's not to keep the lights on, but it is a revenue stream. We get it. There's another line item of revenue. Just treat it as such. My line item for podcast revenue is not in the IR of our fund. Our funds. That's a separate line item. The end. Full stop. All right. We're in agreement. Strong agreement. Yes. You said it perfectly. Okay. All right. This six one that we're going to wrap on here. We're cruising along, so to speak. Should I raise venture debt when I raise my series A? Huh? We put little caveat there.

Should I raise venture debt series A? I haven't looked at your notes. Scott, I'm interested in your thoughtfulness here. I think venture debt is a very cheap insurance policy, but most founders kind of come to it late and think it's something that's going to save their company. So doing it, putting it's kind of the old saying, you need to have money to borrow money. That's very, very true. So when you close that round, A or B or C, usually you see it is a little too early.

You probably don't want to do it at that point. A, B, C, you're going to put something in place that you can draw down in the future. So you're not going to draw it down right away and start paying interest that you don't need to pay. You have the optionality of drawing it down in the future. That's really important. What I see venture debt go wrong is a company has six to nine months of cash. They know they're in trouble.

They've gone to their insiders, their existing VCs, ask for a break. around, the VCs say no, for whatever reason, and they think they can go to the lenders and get money that's going to save the company. The lenders are very good at sniffing those situations out. They do it for a living. Yes, yes. They also know your investors. They will call your investors. It's kind of like trying to pull one over on the real estate broker community. Like, they bought and sold your house three times before you bought and sold it. They know your house better than you do. They know the two previous owners that they know who's going to buy it. Venture debt is not something, they're never going to catch the knife. And I think

the big mistake is when people add on too much of it and they use it as runway. If you have it there as a rainy day fund, you're raising a $10 million series A, some bank offers you a $3 million line that you can draw down in three tranches and it's 50K to set it up or 100K to originate it. Okay, do you want to spend 1% of your cash reserves to have 3 million available in origination fees or whatever? Maybe, maybe. Much better to either not have it or to have it be a small amount because I can tell you if it goes wrong, this is going to blow up in your lap. Yep. And these folks are not, I wouldn't say they're like the mob, but they're not angel investors.

Angel investors are investing their own money. If they lose 25K, they lose it. The mob loses $3 million. You're going to get some cement shoes. And then they're somewhere in between. In other words, they take it seriously. And they say, okay, here's a foreclosure document. We will extend it, but we now want $250K in warrants.

We now want a million dollars in warrants. And then you have no choice but to give them whatever they want. And it can be a little brutal, yes, Scott? Yeah, it can. And if you're over leveraged, the mechanics are, say you raise, take some Vettodeset series A, you're over leveraged. Those Siri B investors, they want to give you money that goes to growth, to power your valuation to help them get an exit, help you get an exit.

They don't want a lot of money going to pay back the lender that you already, from the money already took. So that's really the rub there. Any kind of over-leveraging is really dangerous. And like you said, I only recommend this for insurance if you're doing really well. It's a great tool to extend your own way. But if you're a mediocre company to a bad company, do not pull it down. It's just going to make everything worse and it just, it gets pretty messy.

All right. Listen, great job. Scott, you clean up all these messes I give to you and you're just so generous with your time, especially to the two or three person companies, which I really appreciate your true man. Cruze Consulting.com slash twist. If you want to work with Scott, he's my guy. And if you want to watch all the startup basics and just check them off so that you know you're doing things right, this week in startups.com slash basics.

I know people don't like to do chores, Scott, but we all have to do our chores. Yes. Correct? We do our chores. And you know what? Do your chores. Keep the house clean.

It's like, um, it's just good discipline to have. It's good hygiene. If you brush your teeth, you clean the dish, the dish is in the sink. This is the same thing. Accounting, legal, HR,

just get it right. I always tell people, Scott, tight is right when it comes to these particular items. You can play games with your design, U.S. You can have fun. be creative. We don't need your creativity applied to accounting, legal, or HR. These are not places for creativity. These are regulated, serious, buttoned up pursuits. Do your chores. Yes, Scott?

I totally agree. It also just makes life so much easier. That's the main thing. Look, you got a guy like Scott sitting there. He's got the sweater on. He's got the three-quarter zip. You can take them seriously. Accounting shows up with the three-quarter zip. You know they're here for business. They got the college shirt under it. It's no longer suits. You don't have to wear the suits and ties, but you do have the three-quarter zip. You look great. You come in, you teach these people how to do it. I love you for it, Scott. Thank you for doing it. It's great to see you again, and we'll get some ramen soon. All right, everybody, once again, this week in startups.com slash basics. We'll see you next time. Bye-bye.