How to start a startup and raise funds in it (part 2)

Original author: StartUp School Radio
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The first part .

Divide the company fairly



Aaron : When it comes to stocks, one of the main issues a startup faces is how to split the initial capital. I think the Internet is full of people with complex equity calculators calculating how much each founder will receive in one version and in another version. When it comes to how to distribute shares between the founders, what would you advise? What proportion is ideal in terms of company development and in terms of its success?

Kirsty: When we select companies for financing and look at the structure of companies' equity, we expect to see a relatively equal division of shares. This is not strictly 50 to 50, but a close proportion. When we encounter a situation where one founder has 90% and another has 10%, this is an alarming signal for a number of reasons. One of the problems may be that in reality they did not think through this separation to the end.

Often the founder argues his 90% as follows: “I worked on this project for three months, I wrote the code for the first prototype and I invited the co-founder then, so I have the right to the company’s assets. That was my idea. ”

Aaron: And so I sit and say: “You know, that was my idea. I am a genius and deserve 80% of the company. In addition, you know, it was I who raised the first 15,000 dollars and invested 5,000 of my own funds. I deserve all 90%. " That's fair, isn't it?

Kirsty : There are many reasons why this does not work. And the main one is that three months of work on the project is a drop in the ocean on a company-wide basis. If you want to lead it to success and go on an IPO, then you may have to work for ten, fifteen, and twenty years. Therefore, three months do not seem such a significant contribution. And, you know, in many companies the final product with which they enter the market is a bit like the initial idea.

Let's say the idea is yours, but after it was born, a large amount of work follows on its implementation. And here we return to the concepts of quality communication and teamwork. And if you position yourself as equal partners, each of whom has a voice in the company, this should be reflected. And, yes, if one of you invested money to finance the company at an early stage, you can allocate an additional couple of percent to this founder and add a few shares.

From experience, I can say that radical imbalances do not work. This is one of those things that harbors grudges: everyone is under stress, everyone works until late. But you know that one of the founders works for the huge potential benefits that the second does not have. And the latter may ask: “Is it worth it?”

Aaron: Reflections on the potential benefits for me are always too complicated, because, in truth, most of the shares that the company issues at the start are worthless and are unlikely to ever cost. And trying to figure out who will earn more under the fictitious scenario in which the company succeeded is a difficult and thankful task.

If a company costs $ 100 billion, 10 percent is good money. But, alas, they do not give the feeling that you are an equal partner in the company. If both partners have worked in the company for 10 years, put equal efforts into the project, and one of them still feels like a junior companion - this leads to trouble. As mentioned earlier, coupled with poor communication, this affects every decision in the company.

Kirsty: Yes, it is reflected. In everything. It can even turn abstract things into a problem. It all comes down to talking to each other. You need to make sure that the founding team is happy and that no one is feeling unfairly left out. And also that everyone is still ready to work hard for the benefit of the company.

Aaron : One of my favorite moments when interviewing companies that are 90 to 10 divisions is when we start explaining something like the following: “Just for information, such a division as you have has a right to exist if you discuss it inside company. But in our experience, traditionally shares are divided roughly equally. " And then the younger partner's eyes light up. He thinks to himself: “Wow! I didn’t even know about it. "

Thus, we educate entrepreneurs, invite them to an internal dialogue and help companies find themselves in more favorable conditions for entering the market. And this is awesome. We carry this message, but dictate nothing. Shares in the company may be unequal, but there must be a good reason for this and similar conditions should be negotiated and agreed upon by all partners in the company. 90/10 can't be dictated by just having an idea ...

Carolyn: I often draw attention to the fact that the founder with 10% is trying to justify his share, and the founder with 90% is simply present at the meeting. It looks like Stockholm Syndrome, right? The junior companion says: “I have 10% because the project idea is not mine and I do not have the appropriate education.” Or calls another reason. And I listen and think, “Lord, they didn’t discuss anything among themselves.”

Use vesting to protect your company.



Aaron : When you decided on the division of shares in the company - how many percent each side receives - how do you structure the distribution of shares? Do participants get them upfront? “Ok guys, I have 50% of the company. The first day of the company and I get 50% of the shares. " Does it look like that?

Carolyn: Basically, participants purchase them under a limited stock purchase agreement. You decide how to distribute the shares among the founders and then buy them. You buy them under a contract in which there are many important legal details, but the key concept is vesting. The idea of ​​vesting is that you buy your own shares. You own these shares. You can vote with their help. However, they are subject to the so-called loss of the right to share. This means that the company can return them if you left the project or were dismissed from the company before the right to shares was fully secured to you.

Aaron : I think this is a very strange concept if you are not familiar with it. That is, you own something, but the company can take it from you. You do not have full ownership, despite the fact that you paid for these papers.

John : As Christie noted, the founders need to communicate and come to equal interests. Westing helps to build all the key elements of the company with which it can correctly enter the market and move further in the right direction. For example, if someone leaves the company after working for a couple of months and owning 50%, this will negatively affect further development. The company will be in a terrible situation. Westing may not look like the fairest tool, but it is important because it is aimed at the long term. It is impossible to build a company in a night. A company is not only an idea. It is important to implement the company's strategy and vesting - this is the basis for the future.

Aaron: It seems to me that one of the important points that people lose sight of when starting a company is that it needs to be protected. We are talking about the benefits for the company and its success in the long run. This benefit does not necessarily coincide with the private interests of individual founders.

Theoretically, the founder can leave the company, taking his 50% and be satisfied, but in fact, this is a bad idea. The company will retain a small share, and it will issue new shares for investors or future employees to create a sense of ownership, ignoring the fact that in the long run this situation will impede the success of the company. Founders should understand this: 50% of nothing will remain 50% of nothing.

Carolyn: I think it's worth warning entrepreneurs about another bad idea. I am sure that some people think in this vein: “Well, even if the founder leaves the company with 50% of the shares, I will simply issue new, millions of new shares and shower me with them. Myself, the remaining founder. " It sounds promising. But, unfortunately, that doesn't work like that. There is a difficult legislative reason for this - I’ll just say that it’s simply not possible to do this. Therefore, do not think that you have such an alternate airfield. Do not think that this is a good excuse not to use the hosting.

Perhaps this is not even a matter of blurring shares. Here's the thing: if you added value to a company, you can no longer buy shares at face value. You have to pay fair market value for them. And she can be very high. The question is, can the remaining founder redeem them for cash? Of course, there are workarounds, but all of them are archy complex and we strongly recommend against using them.

John: Right. There are also other problems. After the release of the film “Social Network” in Y Combinator, there was a period when the founders came one after another and asked for strange changes to their constituent documents. Such, for example, as the possibility of special voting 10-1 or special preferences that would allow the founders to maintain control over the company. And that’s great. We are for the founders to maintain control over the company. But we do not just use in our practice the standardized constituent documents that we spoke about earlier - this is really their best option.

When changes are made to the familiar form and special points are added, this leads to unforeseen consequences: for example, potential investors study your documents more closely - an assessment of the financial condition of a company takes longer. Questions arise for a startup when raising funds - difficulties may arise. There are other reasons: for example, when buying stocks, their value may vary. We developed standard templates of constituent documents, based on practical experience, over time, identifying the most favorable conditions for the launch of the company and its development.

What to create - a limited liability company, a corporation of type “S” or a corporation of type “C”?



Aaron : The last question regarding the direct creation of the company that I want to discuss is the question of which legal entity to create and where? Delaware is chosen by lawyers almost by default. But I remember that when I founded my own company, we wondered “Do we need to establish an LLC? Do we want to be an S type corporation? Type C corporation? "We didn’t even know what the difference was between them. A conversation with a corporate lawyer came down to the advice to establish a limited liability company:" Of course, LLC. Excellent tax incentives. Pluses in this, pluses in that. "And It’s not difficult to create such a legal entity.We were in New York and registered the company there.
Why are all startups today, regardless of location, advised to establish a Type C corporation in Delaware?

Carolyn : When entrepreneurs choose to create an LLC or any type of corporation for them, acquaintances of lawyers advise creating an LLC: “This is the best option, in terms of taxes.” And perhaps this is so. Especially if you have plans for a small sustainable business in a particular state.

But, from the point of view of what you plan to create a successful company - and by successful we mean a large company with the possible involvement of venture financing - this form of organization is not suitable for you. Now, perhaps you are looking for the best solution for paying taxes, but you need the best solution for success. Companies that receive external investment must be type C corporations.
Of course, limited liability companies can also receive external investment. But growth companies funded by venture capital are type C. corporations.

The reason we choose Delaver ... it’s important to note that a corporation can be perfectly created in any state. But Delaware is the unconditional favorite of all corporate lawyers, mainly because there public companies are in the most favorable legislative conditions - there is a carefully developed law enforcement practice. The Delaware State Chancellery has a practice of applying legal rules regarding, for example, legal and fiduciary duties - and other subtleties important to public companies.

This practice is leaked to private companies, as the laws of Delaware are familiar to almost all corporate lawyers. They are easy to interpret, and Delaware immediately comes to mind when asking for advice. It is very easy to be there from an administrative point of view: you can create a company quickly, simply and cheaply.

Aaron : The last thing I want to say on this issue is that it seems that there is nothing complicated in creating a company. I agree with John that if you do not show off and adhere to the standard templates of constituent documents, you will find yourself in a winning situation. Put all your efforts, ideas and innovations in the essence of the company - its activities, and not in its form.

Recently, we were faced with a case, the details of which we will not advertise when the young company made a big mistake in creating a legal entity. It got to the point that they had to go on a new round of investment and they were in an absurd situation. Carolyn and John saw many such companies in a situation of absurdity. And this absurdity can seriously harm the whole enterprise. Fortunately, then he didn’t do any harm. But such errors bring a huge headache and result in very high costs for paying for the services of lawyers. Better stick to standard templates.

Track capitalization table



Aaron : Let's move on to the next interesting moment for lawyers, when the history of financing comes into play when creating a company. The moment you ask yourself, “What does our capitalization table look like?”

The term “capitalization table” seems simple and obvious to everyone. However, last week The Economist published an excellent article stating that they began to work seriously with this document relatively recently. Meanwhile, a clear understanding of who owns what is necessary. Kirsty, tell us what the capitalization table is and why is it so important?

Kirsty: In its simplest form, the capitalization table reveals the owners of the company. Initially, when creating a company, only two or three founders of the company will be introduced into it. But as soon as you start hiring employees or attracting investors who will also become shareholders, you will need an understandable way to keep track of the table - you need to understand how the company is represented and what its share capital structure is.

In fact, the capitalization table is simply a list of persons that indicate the number of shares and the percentage of the company that they own. The table can become more complex if you provide options to employees. Suppose an option has been exercised or these employees have left the company - what will happen to these options? In general, the table will become complex in a short time. The most important thing is to always have an idea of ​​who owns the shares of your company.

Aaron : What happens if there are too many shareholders? What problems await entrepreneurs if they are no longer able to keep track of the capitalization table?

Kirsty: I believe that if you do not know who owns your company, you are in big trouble. As a rule, this information is accessed in difficult times. For example, to understand who your shareholders need if you are conducting a round of financing by issuing new shares. Or, for example, you have attracted venture capital investments and you need to affix the signatures of all shareholders of your company.
And if you do not have a clear list of shareholders, or an idea of ​​who they are, it is very difficult to do. As a result, you wade through piles of documents, trying to find the agreements you signed with them, trying to restore them. At such times, you already have enough worries. This is a matter of company hygiene: the availability of this table and the introduction of relevant information into it will not require significant effort and time. But if she is not at hand, you will have big problems.

Aaron : That is so. Imagine your capitalization table is starting to get more complicated. This happens either when you start issuing promotions for your employees, or when you begin to actively raise funds. All venture capitalists and business angels appear in your table. First fundraising - usually what kind?

Kirsty : It can be of different types.

Aaron : From whom does this money come and what tools are used to bring this money?

Kirsty : People who invest in a company do not receive shares immediately. They use tools such as convertible debt. This means that the investor is investing money now and at some point in the future, and this money will turn into shares later. Despite the fact that these people are not shareholders at the moment, you should add them to the table and know who all these people who have invested in your business are.

When you accept money, you need to understand how much of the company will go to these people when they receive their shares. If as a result you give 50% of the company, then you as a founder have little left. This also needs to be understood.

If you give away too much of the company at an early stage, then when you go to the next round of financing - investors will start buying shares in real time - they will want to take even more from the company. And before you realize this, the creators of the startup will own low unambiguous interest for the company. This, in turn, will not motivate to work. It is very important to understand the situation correctly: how much money do you take, on what conditions and what it threatens in the future.

Aaron: Since we are analyzing what happens at different stages, one of the things that I recall is that the first round of financing, as a rule, is not an estimated round of selling property in the form of securities. I think that most people who think about investing think like this: “I’ll go buy shares on the stock exchange. These are shares without a fixed dividend. I know its price. ” If I acquire a stake in a company, shouldn't I know their value? Why is selling stocks without a fixed dividend not the preferred way to raise money?

Carolyn: There are two reasons. I think startups tend to use convertible rounds when the price is not fixed, because it is a faster way to make money. Throughout my career, I have watched how the mechanics of the evaluated rounds became simpler, but at the same time, investors still conduct a financial assessment of your company.

They also conduct legal due diligence: they study your contracts and constituent documents. This is the whole process. Financial documents also appear, which together are lawyers of the startup and the investor company - negotiations are underway on them. This is also a long process.

The estimated round is appropriate when the company is already at the stage when it attracts $ 1.5 million or more. But those companies that plan to “shoot” and go through certain milestones do not want to waste time waiting for the results of the investor check and company assessment: for them, convertible rounds are the best way to get the so-called seed investments. First, you attract money to the company, and the conversion of these instruments occurs during the evaluated round.

Aaron: One of the curious points that all three of my interlocutors emphasized in the conversation is that we return to the idea of ​​standardized processes that allow activities to pass quickly and easily. In this case, the investor thinks something like this: “I would like to assess the financial condition of the company. I would like to set my own price. I need more time to make an investment decision. ” And startups say, “No, I need money now.”

This is because, for startups, time, rather than money, becomes the most valuable resource at this stage. How much they have time to do before they die. How much time do they have in order to satisfy the quality of the product of their users. Therefore, creating templates is a great initiative in support of startups. Also, thanks to my interlocutors today, YC supported the convertible loan tool as a way to invest in the company in the early stages. This is a quick and easy way. This brings a startup back to what it should do - create a product.

John: Absolutely agree. I believe that evaluating a startup is very difficult. It is difficult to come to a common opinion when a company is in its infancy. And working with standardized documents is very convenient. A convertible loan tool is also very convenient because it allows the founders of a startup company to focus on business. At this point, wasting time on anything else, such as strange voting arrangements, is unwise.

We have already seen companies that ceased to exist, while trying to raise money. And this is a big mistake. At Y Combinator, we always advise talking to users. Focus on your business. Write the code. Exercise to stay healthy. Do not go crazy. This is your goal. It should not sound like this: "Okay, we need to attract funding when we get the first users." Do not lose sight of the state of affairs of the company. Losing a startup by filling out documents is a crime.

Aaron : Solve all financial and legal issues in a short time and get back to work on your product and company.

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