These FAQs deal with issues that come up very early, which is to say they should come up before you take any capital from any third parties; before you start paying folks to develop your ideas, technologies, software, etc.; and before you start marketing or selling your product/service, or disclosing any of your “secret sauce” to anyone not under a written confidentiality agreement.
What Should You Do Before You Raise Capital?
Many entrepreneurs have gone straight from having a good idea to telling people all about it and pitching investors to fund it. Big mistake. Being quick on the draw is a good skill for an entrepreneur, but don’t pull the trigger until the weapon is clear of the holster. When launching your business and pitching for capital, these are some important steps to take before lighting the fire:
- Choose the right legal structure for your business, and get it established.
- Assess whether your business has (or needs) ownership of or access to any intellectual property rights and if so, establish and protect the same.
- Make sure that anyone with whom you share your secrets (business, technical, ect.) has signed an enforceable agreement not to take or use those secrets for any purpose other than for your benefit. And that anyone whom you ask to develop any such materials (software code is a good example) has agreed in writing that such things developed on your dime belong exclusively to your business.
- Figure out who owns your business. If you own all of it, that’s great. But make sure any individuals who might think they own any part of your business knows that they don’t. If there are owners other than yourself, figure out who owns what and get it in writing. And don’t forget to think about what happens to everyone’s ownership if/when they leave the business, voluntarily or otherwise.
- Who is going to run the business? That is, who is really in charge, and how far does their authority extend vis-à-vis the rest of the team?
- Finally, do yourself a favor and evaluate whether your great idea is a good business idea, and how it might be realized as such in terms of both a business and financing model that works for you, your customers, and your investors. Your first efforts in this area will probably not take you very far in the real world, but if you cannot figure out something plausible at the start, you are not likely to attract much in the way of capital to get you anywhere at all.
What Form Should Your Business Take?
Choosing the structure of your new company involves an analysis of many factors, including tax structures and implications, ownership restrictions, attractiveness to investors, and structural complexity. The biggest advantage to incorporating as a C-corporation is its attractiveness to investors, namely venture capitalists (VCs) and angel investors. Additionally, it allows for a great deal of flexibility in terms of the ownership and capital structure. A limited liability company (LLC), on the other hand, is not attractive to investors. In fact, many investors will require an LLC to convert to a C-corporation prior to making their investment. An S-corporation can provide many of the same benefits as that of a C-corporation. However, it is very restrictive in terms of its ownership and capital structure, and is almost never a viable option for early stage companies.
Where Should Your Business Be “Domiciled?”
Every state has its own corporations code. In terms of substance, most are pretty similar. In terms of administrative costs (the costs of keeping “in good standing” with that state’s corporate regulatory folks) there are some variations, but in the grand scheme of things not a lot.
And yet almost two-thirds of corporations in the Fortune 500 are incorporated (domiciled) in Delaware. A similarly large share of venture-backed private companies, even those that are physically located in California, are domiciled in Delaware as well. As lawyers for venture-backed companies, we’ve often been asked to “move” a venture-backed company to Delaware from some other state. We’ve never been asked to move a venture-backed company out of Delaware to another state.
There are a number of reasons for this, and if you are interested, take a look at our blog on the topic. Unless you have a really good reason otherwise, if your business is going to take the corporate form, you may want to consider incorporating in Delaware.
What About Ownership and Protection of Business “Secrets?”
We are continually surprised by the number of start-up teams we see that don’t know exactly who owns which pieces of the business; what assets belong to the business as opposed to a member of the team or some third party; and even who exactly is on the team as opposed to who is just helping out. Dealing with these issues can be messy and stressful, which is why teams often punt on it. A word to the wise: if you think these issues are problematic at the beginning of the project, wait until you see how complicated they are six or 12 months in, when the business has some real value, and maybe even an investor ready to write a check – assuming they know what they are buying and who they are buying it from. So, do yourself a favor and don’t build a lot of value in your business before you figure what the business' assets are and who owns them.
Do You Need a Business Plan?
In the age of the Lean Start-up, many entrepreneurs have concluded that they don’t really need a business plan. They are wrong. Well, most of them.
It is certainly true that there are some entrepreneurs out there who are so compelling that they could likely raise a lot of capital from name-brand VCs without even telling them what they plan to do with it. Mark Zuckerberg, for example, could probably raise a ton of capital with a “trust me, I’ve got a great idea” email. If you are in that kind of situation, you probably don’t need a plan, or frankly, to be reviewing any of these FAQs.
Let’s assume you are not a Zuckerberg-sort of entrepreneurial commodity. You should have a plan. Why?
Even though your first business plan is almost sure to evolve significantly long before your business finally succeeds (or fails), developing that plan is important for a number of reasons:
- It forces you to think of your idea in business terms. There are lots of good ideas out there that are not good business ideas, or good scalable business ideas. Putting together a business plan for your idea forces you to ask yourself in a serious way whether your good idea is a good idea for a scalable business.
- Closely related to #1 above, but worth special emphasis, you need to show that there is at least one plausible business model for your idea. That is, that you can show one very profitable and plausible way to get your customer value proposition to the customer.
- It forces you to think about how to build your business in steps, which is critical to understanding how much capital you need to accomplish each milestone. Getting that right is critical to getting investors on board, and to minimizing how much dilution you are going to suffer as those investors come on board.
- It forces you to confront the fact that investors care more about their liquidity event (the exit) than they care about the long-term health of your business. Yes, those things often overlap to a large extent, but they don’t overlap completely. Your investors need to see in your business plan that you have a plausible plan for, and you are personally committed to, achieving liquidity for your investors – something that in most cases will mean selling your business to a third party.
None of this means that your business plan needs to be long and full of operational details. Most of the best business plans we’ve seen come in at 10 to 20 pages, maybe a bit longer for more capital-intensive research-based start-ups with long investment horizons and significant regulatory challenges. And the good ones generally are not so much business plans, but rather documents aimed at potential investors that focus on how compelling the investment opportunity is. The customer value proposition is critical, not in and of itself, but rather in relation to how it will profit the investor at the exit.
Who Owns the Business?
If you are the only founder, and no one else has a claim on the initial ownership of the business, life is simple. Whatever form the business takes – corporate, LLC, partnership, etc. – you own all of the shares/units of the business. You still need to document that, but there is not too much to figure out.
On the other hand, most start-ups are the brainchild of two or more folks, often referred to as “co-founders,” each of whom has some ownership interest in the business from the get go. It is critical to get the “who owns how much” question figured out and documented as soon as possible. No matter how close and trusting the various co-founders are, as time goes on and the business makes progress and becomes more valuable, you can be all but certain that various co-founders will develop different takes on who added what value, and memories of earlier undocumented “agreements” about ownership will change. It is not uncommon for these kinds of disputes to seriously damage and even destroy otherwise promising young companies. In all the excitement and esprit de corps around getting the business launched, don’t forget to get the deal between the co-founders down in writing and executed.
Which leads to a related question…
What is “Founder Vesting” and Why is it Important?
When a team of founders divvy up ownership of their start-up, they too often assume that whatever division they decide upon upfront will be appropriate going forward. Then, one of them decides the whole thing isn’t as good an idea as they thought, and quits. What happens to their stock? Does she get to keep all of it, even though they left a couple of months after the company formed, and benefit from all of the likely years of sweat the others will put in building the value of the business? Or, do they have to return some (or even all) of their shares to the company? Figuring out the answer to that question, first and foremost, is what founder vesting is all about. And it is something that is a lot easier to figure out at the beginning than it is to figure out when the issue is ripe, like when a founder is leaving, with their stock firmly in her hands.