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Legal and Accounting Basics for Startups with Kirsty Nathoo and Carolynn Levy (HtSaS 2014: 18)
33 segments available
Lecture Transcript: http://genius.com/Kirsty-nathoo-lecture-18-mechanics-legal-finance-hr-etc-annotated There's a lot that goes behind the scenes in running a startup. Getting the legal, finance (equity allocation, vesting), accounting, and other overhead right will save you a lot of pain in the long run. Kirsty Nathoo, CFO at Y Combinator, and Carolynn Levy, General Counsel at Y Combinator, cover these very important topics in this lecture. See the slides and readings at http://startupclass.samaltman.com/courses/lec18 Discuss this lecture: http://startupclass.co/courses/how-to-start-a-startup/lectures/64047
Segments Timeline
Introduction to Startup Mechanics
Kirsty Nathoo and Carolynn Levy introduce the lecture on the essential legal and financial mechanics for startups. They emphasize the importance of understanding these basics to avoid future complications and focus on building a successful company.
"in general console uh Kirsty and Carolyn and they're going to talk about uh finance and legal mechanics for startups. Um this is certainly not the most exciting of the classes. Sorry, but if you get t..."
The Importance of Legal Structure
Nathoo and Levy discuss the necessity of forming a separate legal entity for startups to protect founders from personal liability. They highlight the significance of choosing the right state for incorporation, with Delaware being the preferred option due to its clear laws and investor familiarity.
"beginning. Um, I was watching Paul Graham's video and at one point he says, "Founders don't need to know the mechanics of starting a startup and I thought, oh no, that's exactly what Sam titled this l..."
Avoiding Common Incorporation Mistakes
The speakers share a cautionary tale about a startup that incorrectly formed as an LLC in Connecticut instead of a Delaware corporation. They stress the importance of keeping the incorporation process simple and familiar to avoid costly mistakes.
"So as Sam mentioned, we were also worrying that it's going to be pretty boring for for you to listen to a an accountant and a and a lawyer talking about this. Um, you know, you've had some really amaz..."
Steps to Incorporate in Delaware
Nathoo outlines the straightforward steps to incorporate in Delaware, including filing basic paperwork and creating essential company documents. She emphasizes the importance of maintaining a clear distinction between personal and company actions during this process.
"assets IP inventions other things and that the company needs to protect those. So we'll talk a little bit more about that about how to raise money um hiring employees and entering into contracts. So t..."
The Importance of Document Management
The speakers highlight the critical nature of keeping signed incorporation documents organized and secure. They explain that having these documents readily available is essential during high-stress situations like fundraising or acquisitions.
"probably already know this, but the primary purpose forming a separate legal entity is to protect yourselves from personal liability. And what that means is if your company ever gets sued um you know ..."
Understanding Equity Allocation
Nathoo introduces the concept of equity allocation among co-founders, explaining its significance in startup dynamics. She emphasizes that execution is more valuable than the initial idea and warns against giving disproportionate equity to the idea's originator.
"companies that are Delaware corporations. Most of their investments are probably Delaware corporations. So if you are also a Delaware corporation, then everything just becomes much more simple, right?..."
Equity Splits and Team Dynamics
The discussion continues on how to fairly allocate equity among founders. Nathoo stresses that equal ownership fosters trust and collaboration, while disproportionate splits can indicate underlying issues within the founding team.
"tell you a story. We had a company at YC uh about 2 years ago that was originally formed uh as an LLC in a state that I'll I'll say Connecticut. Um the founders had some lawyer friends there who said ..."
Long-Term Commitment and Equity
Nathoo emphasizes the importance of all founders being committed to the startup for the long haul. She argues that past contributions should not dictate equity splits if all founders are equally invested in the future success of the company.
"incorporate all companies the same way at Y Combinator is because it's easy. So, don't get fancy. Just save yourself some time and money. Okay. So, once you've decided that you're going to be a Delawa..."
Final Thoughts on Equity Ownership
The speakers conclude the equity discussion by noting that in successful startups, there are no significant disparities in equity ownership among founders. They reinforce the idea that teamwork and shared commitment are crucial for startup success.
"any inventions or any code or anything that you as an individual create so that the company actually owns that. Um and remember at this point it's it's a really good thing to think about you as founde..."
Equity Allocation: The Founders' Dilemma
Kirsty Nathoo discusses the importance of equitable stock allocation among startup founders. She emphasizes that while equal ownership isn't mandatory, significant disparities can indicate underlying issues in trust and commitment among the founding team. The segment highlights the need for founders to be aligned in their vision and dedication to the startup's future.
"founders? And from our perspective the simple answer is probably yes. Um, our mantra at Y Combinator is that um, stock allocation doesn't have to be exactly equal, but if it's very disproportionate, t..."
The Importance of Stock Purchase Agreements
Nathoo explains the necessity of formalizing stock ownership through stock purchase agreements. She draws parallels to larger companies, stressing that founders must sign documents to secure their shares. The segment also introduces the critical 83(b) election, which can significantly impact individual and company taxes if not properly filed.
"which we call those, you know, with the highest valuations, there are zero instances where the founders have had significantly disproportionate equity split. All right. So you've had the conversation ..."
Understanding Vesting: Protecting Your Equity
This segment covers the concept of vesting, which ensures that founders earn full ownership of their shares over time. Nathoo explains the standard four-year vesting period with a one-year cliff, illustrating how it protects the company from losing equity when founders leave prematurely. The discussion emphasizes the importance of vesting for both solo and co-founders.
"there's one very very crucial piece of paper that we talk about until we're blew in the face to everybody because there's actually no way to go back and fix this. And this is actually one of the thing..."
Why Vesting Matters for Founders
Nathoo elaborates on the reasons for implementing vesting among founders, including maintaining equity fairness and incentivizing long-term commitment. She highlights how vesting aligns the interests of all founders and reassures investors that they won't lose significant equity if a founder departs. The segment also discusses the cultural implications of vesting within a startup.
"next 3 years. So here's an example. Founder buys stock on Christmas day, let's say, and then quits the company on the following Thanksgiving. So before the year has passed. Um in that case, the founde..."
Raising Capital: The Next Steps
As the lecture transitions, Nathoo introduces the topic of raising capital for startups. She outlines the two primary methods of fundraising: setting a price for investment or leaving it unpriced. The segment sets the stage for discussing the logistics and paperwork involved when investors agree to fund a startup.
"So what are the takeaways from here? I would say um vesting aligns incentives among the founders if they all have to stick it out and grow the company before any of them get any of that company. And t..."
Convertible Notes and Valuation Caps
Nathoo explains the mechanics of raising funds through convertible notes and safes, emphasizing the importance of having signed documents. She discusses how valuation caps work, providing an example of how early investors can benefit from lower share prices in future funding rounds. This segment highlights the need for clarity in investor rights and documentation.
"money. And usually the way that this is done is through convertible notes or safes. And again, this is a two-way transaction. So there's a piece of paper that says, for example, that an investor is pa..."
The Impact of Dilution on Founders
In this segment, Nathoo discusses the implications of raising funds through safes and the potential dilution of ownership for founders. She emphasizes the need for founders to be aware of how much equity they are giving away and the importance of understanding the long-term effects of these financial decisions on their ownership stake.
"reward for being in early. So again, this is another situation where you need to make sure you have the signed documents um and you you know where they are because different investors may have differe..."
Choosing the Right Investors
Kirsty Nathoo stresses the importance of selecting sophisticated investors who understand the risks of startup investments. She warns against accepting money from unsophisticated investors, as they may not grasp the long-term nature of startup growth and could create complications for founders. This segment provides critical insights into investor selection.
"whole process so that you can see where this is going to lead you down the road. The other thing to bear in mind is that the invest in investors should be sophisticated. Um, and by that we mean that t..."
Navigating Investor Terminology
Nathoo addresses the necessity for founders to familiarize themselves with investor terminology and requests. She highlights the importance of understanding all terms in financing agreements, as ignorance can lead to unfavorable outcomes. This segment empowers founders to take charge of their financial literacy.
"points here is keep it simple, raise your money using standard documents. Um, keep make sure that you have people who understand what they're getting into and understand what you're getting into in te..."
Investor Requests: Board Seats and Advisors
In this segment, Nathoo discusses common investor requests, such as board seats and advisory roles. She advises founders to be cautious when granting board seats and emphasizes that investors should naturally contribute value without demanding additional compensation. This guidance is essential for maintaining control and direction in a startup.
"figure this figure this stuff out. and we're going to go over four common investor requests. So, the first one is board seat. Um, some investors will ask for a seat on your company's board of director..."
Understanding Prerogative Rights
Kirsty Nathoo explains prerogative rights, which allow investors to maintain their ownership percentage by purchasing additional shares in future funding rounds. She clarifies how these rights can help avoid dilution but also highlights the potential impact on founders' equity. This segment is crucial for understanding investor rights and their implications.
"investors who can help should do so. Asking for additional shares is just an investor looking for a freebie. Okay. Next, we're going to talk about pro ratites. What are prerites? Some of you may have ..."
Information Rights and Investor Communication
Nathoo discusses the importance of information rights for investors, advocating for regular updates while cautioning against excessive demands. She encourages founders to maintain open communication with investors, as it can foster support and collaboration. This segment emphasizes the balance between transparency and investor overreach.
"information rights. Investors almost always want contractual information rights about to get certain information about your company. Um, giving periodic information and status updates is not a bad thi..."
Managing Business Expenses Responsibly
In this segment, Nathoo outlines the significance of managing business expenses after securing funding. She explains how proper expense management can impact tax returns and emphasizes the importance of separating personal and business finances. This guidance is vital for founders to ensure responsible use of investor funds.
"financing. Okay. So then moving on to after you've got that money, um you know, you've raised some money, the the company bank account's probably showing more zeros in it than you've ever seen in your..."
The Consequences of Misusing Investor Funds
Kirsty Nathoo shares cautionary tales about founders misusing investor funds, highlighting the serious repercussions of such actions. She stresses that founders must treat investor money with respect and accountability, reinforcing the ethical responsibility that comes with managing startup finances. This segment serves as a critical reminder for founders.
"spend how you please. And believe me, we've had some horror stories of founders who take that approach. Uh we had we had one founder that we knew of who took investor money and went off to Vegas and b..."
Keeping Track of Receipts
In this segment, Nathoo emphasizes the necessity of maintaining accurate records of business expenses. She advises founders to keep receipts organized for tax preparation and to facilitate communication with accountants. This practice is essential for distinguishing between business and personal expenses, ensuring compliance and financial clarity.
"telling any of the telling them what any of those lines were? And if you were, it's probably not a business expense. So the other thing to bear in mind is that, you know, you're busy running your comp..."
Founders as Employees
Kirsty discusses the legal implications of founder employment, asserting that founders must be compensated for their work. She warns against the dangers of unpaid wages and the legal liabilities that can arise from neglecting payroll responsibilities. This segment highlights the importance of treating founders as employees to avoid potential conflicts and legal issues.
"them. So if nothing else that you remember, do not go to Vegas on investors money and spend that money wisely. Okay. So um in this section we're going to talk about just doing business and we're going..."
Navigating Founder Breakups
This segment addresses the sensitive topic of founder breakups and their potential complications. Nathoo explains how unpaid wages can lead to leverage in disputes, complicating the separation process. She advises founders to maintain fair compensation practices to prevent ugly confrontations and ensure a smoother transition if a breakup occurs.
"companies have to pay payroll taxes. We had a YC company that completely blew off their payroll taxes for 3 years. It was a huge expensive disaster and in extreme cases, people can actually go to jail..."
Hiring Employees: The Basics
Kirsty outlines the fundamental aspects of hiring employees, emphasizing the legal considerations involved. She explains the differences between employees and contractors, detailing the implications for tax responsibilities and IP assignments. This segment serves as a primer for founders on the essential legal frameworks governing employment.
"And even worse, in a sense, the remaining founders are kind of working for that exfounder, right? Because they're building all the value in the company. And the ex-founder who got fired is just sittin..."
Understanding Employee Classification
In this segment, Nathoo dives deeper into the distinctions between employees and contractors. She highlights the importance of proper classification to avoid IRS penalties and outlines the documentation required for each type. This knowledge is crucial for founders to navigate the complexities of hiring and ensure compliance with employment laws.
"contractor. And there are subtle differences to this classification and this is important to get right because the IRS takes a big interest in this and if they think you've got it wrong they will come..."
Payroll Responsibilities for Startups
Kirsty discusses the critical payroll responsibilities that come with hiring employees. She emphasizes the need for workers' compensation insurance and verifying employee work authorization. This segment underscores the importance of using payroll service providers to manage these obligations efficiently, allowing founders to focus on their core business activities.
"over to the relevant state and federal authorities. And at the end of the year, the employee receives what a W2 form, which will then get used to prepare their personal tax returns. So, as Caroline ha..."
Best Practices for Firing Employees
In this concluding segment, Nathoo shares best practices for firing employees, emphasizing the need for prompt action. She discusses the emotional challenges of letting go of employees, especially friends, and the importance of making decisions that benefit the company. This segment provides valuable insights for founders on handling difficult personnel decisions professionally.
"understand the basics of employment. We're running short on time. Yeah. Um Okay. So I can breeze through really fast firing employees slide and then should or should we cut it off now for questions? W..."
Key Takeaways for Startup Legitimacy
In this segment, Nathoo outlines essential practices for maintaining legitimacy in a startup. She stresses the importance of keeping things simple, understanding equity ownership, and ensuring that intellectual property is assigned to the company. These foundational elements are crucial for long-term success.
"terminations. Uh okay. So then we had this section that we called legitimacy which actually kind of goes into a little bit more about um you know how to be how to be a real company, how to be sort of ..."
Finding the Right Accountant
Kirsty Nathoo explains the difference between bookkeepers and CPAs, advising startups on when to engage accounting services. She emphasizes the importance of recommendations and highlights services that can streamline the accounting process, ensuring that founders can focus on growing their business.
"paperwork for that. Make sure that you actually know about the financing documents that you're signing up to. It's not enough to just say, "Yeah, I'll take your 100K." Make sure you actually know thos..."
Navigating Cryptocurrency Challenges
In this concluding segment, Nathoo addresses the complexities of working with cryptocurrencies in startups. She notes the difficulties banks face in dealing with crypto-related businesses and emphasizes that advice must be tailored to specific products, reflecting the evolving landscape of fundraising in the crypto space.
"All things considered, budgeting my budget for, you know, incorporating with a lawyer, for getting legal advice for my first seat round, and then for hiring the first employees, how much money do I se..."