Every entrepreneur begins with the excitement of their idea and how it will transform the world. However, just as important is paying attention to the details that will put your business on a solid foundation to attract the best employees and investors. There is a separation of ownership and management in a corporation and both investors and employees will come on board only if they believe that their equity will increase in value and that the business is structured properly. Here are some of the factors to consider.
1. Delaware C Corporation
One of the first key decisions is the legal form of your company. Venture investors overwhelmingly invest in Delaware C Corporations because they provide limited liability, the ability to issue stock options and multi-classed stock, and tax benefits upon sale for many qualified small businesses. In short, it is the gold standard for high growth startups. At Silicon Road Ventures all of our investments from our family of Funds have been made into Delaware C Corporations.
2. Accredited Investors
It is very common for founders to raise the initial capital for their business from friends and family. To set your company up for later follow-on investment it is essential that you only accept capital from accredited investors. An accredited investor is an individual or a business entity that is allowed to trade securities that otherwise may not be registered with financial authorities. They are entitled to this privileged access by satisfying at least one requirement regarding their high-income, net worth, asset size, governance status, or professional experience. Here is a link to the SEC Website with a more detailed explanation. https://www.sec.gov/education/capitalraising/building-blocks/accredited-investor
3. Option Pool
A key element in attracting top talent to a fast-growing startup is through the use of equity compensation. Every venture backed company should create an option pool that is used to incentivize employees, management, and board members. It is important to keep in mind that the option pool will cause dilution among the existing shareholders and should be created before a venture firm invests.
When issuing stock to employees it is critical to have a vesting schedule in place. The most common vesting timeline is a one-year cliff with a four-year vesting period, where equity does not begin to vest until after the first year and continues through the fourth year. Vesting is essential in ensuring that equity is granted to team members who are helping to build the business. If no vesting schedule exists, the employee has less incentive to stay and build the business.
There are two very important parts of the tax code that every founder should be aware of in setting up a new company.
The first is an 83(b) election that can allow a startup company founder who receives restricted stock to save a substantial amount of taxes because the tax is based on the fair market value of the property when it is granted, rather than its fair market value on the date that it vests.
The second is Section 1202 of the US tax code that strongly incentivizes investments into small and new businesses, like startups. When you invest in a company or receive shares in an early-stage startup (as a founder, advisor or employee), and then hold the shares for 5 years before selling, you may pay 0% in federal income and capital gains tax on the profits.
It is very important to hire an attorney who is experienced in the formation of early-stage startups. It is expensive and painful to unwind early structural mistakes and the use of a qualified attorney will help you avoid these costly errors and is money well spent.
6. The Exit
Each of these building blocks are essential in setting the business on a path for an eventual exit. The two most common exit types for venture backed startups are via acquisition or IPO. It is far more common for early stage startups to be acquired but no matter which path you choose, putting these elements in place in the beginning will pay dividends for you when it comes time to sell your business.