Last revised 2019-12-31; not a substitute for legal advice from a licensed attorney.
Welcome. This page originated with slides I’ve used for numerous guest-lecturer presentations at Rice University; the University of Houston Bauer College of Business; the Houston Technology Center; the University of Texas M.D. Anderson Cancer Center; and elsewhere. (The additional reading section might be of particular interest to some.)
Table of contents
- Co-founders should “put it in writing” early
- A few contract resources
- Intellectual property tips
- Legal traps
- What business form – LLC or corporation?
- Initial tax-related information
- Additional reading
- Working with lawyers
- General business reading for startups
- When a customer asks for a steep discount
- Customer support
- The dangers of landing a big customer
- To take investment, or not?
- Demo days can be dangerous places to start raising money
- Safes as a very-early investment vehicle
- Business insurance
- Avoiding lawsuits
- Bank loan covenants
- Injury- and illness prevention
- Getting paid
- Financial controls
- In general
- Selling the company
- How do I know when my startup has failed?
- Leaving the company as a co-founder
- Share this:
Co-founders should “put it in writing” early
Before co-founders do any significant work on a startup together, they’d be well-advised to put something in writing about how they plan to work together and what their respective roles, ownership, compensation, etc., will be.
Otherwise, things could get really messy if the co-founders were to get into a dispute later, especially if they decided to split up.
See, for example:
• An alleged co-founder coming out of the woodwork when self-driving car company Cruise was acquired, reportedly for $1 billion, by General Motors;
• The tale of woe told at the Hacker News site by an anonymous startup founder;
• The dispute between Facebook and its founder Mark Zuckerberg and the Winklevoss twins;
• Legendary Internet entrepreneur and venture capitalist Marc Andreessen tweeted: “Last 10 years ratio of tech startup cofounder/cofounder serious disputes vs founder/VC serious disputes: 20 to 1?”
• This Forbes article lists the failure to put it in writing as the #1 mistake founders make. The article offers a checklist of issues that could be addressed in a “pre-nup”;
• Here’s a (long) account by a software developer who claims that he and some of his friends were talked into spending a Startup Weekend brainstorming and building a new Web site, only to have the pitch man claim that the result was owned by an LLC previously formed by him and his (absent) business partner. Our Team Won Startup Weekend And All We Got Was A Shitty New Boss (see also the Hacker News commentary).
• In case you get to arguing about who’s entitled to what, you might find this Hacker News discussion of interest. (Spoiler alert: The consensus seems to be that equity in a startup is worth essentially zero.)
• Another HN discussion: Splitting equity among founders (links to an article, with numerous comments by experienced entrepreneurs such as ‘tptacek).
• And the HN discussion about questions to ask a prospective co-founder.
If your company is being co-founded by multiple people, you’ll definitely want to be sure that everyone’s equity vests over time — even that of the original founder(s). Otherwise, one or more of the co-founders, owning a large chunk of equity between them, could leave the company (to get a job, go to graduate school, whatever) yet still own a major piece of the company even though they’re no longer contributing.
IMPORTANT: Be sure to consider an 83(b) election to reduce the chance of later getting hit with a huge federal-income-tax bill without the cash to pay the tax.
A solo founder will probably own 100% of the equity, but if he or she takes investment, the investors will almost certainly insist on reverse vesting, so that if the solo founder later leaves the company before (say) four years is up, then the company the right to buy decreasing percentages of the solo founder’s equity, for cheap.
A few contract resources
Here’s a list of resources that you might find helpful. I don’t necessarily endorse everything in them (except for my own work, of course). A given document might not be right for your particular needs without editing. Remember that small changes in your factual situation could have a significant effect on your legal position; see also the Cautions page.
Contracts, in general
See my free e-book, Signing a Business Contract? A Quick Checklist for Greater Peace of Mind.
Take a look at the Founders’ Accord, in essence a co-founders’ pre-nup, published by a small NYC law firm. Of course it’s not a substitute for legal advice, but it seems to be a useful resource, and it’s almost certainly better than not having any kind of written co-founder agreement at all.
Incorporation and investment documents
Renowned startup accelerator Y Combinator and the equally-renowned Wilson Sonsini law firm have posted a set of organizational documents for an angel-investor round.
A startup called Clerky, founded by some Silicon Valley lawyers, offers to put together Delaware incorporation documents and related materials. The Hacker News crowd seems to like Clerky; the site (and its founders) got a nice review from longtime Silicon Valley startup lawyer and Hacker News legal doyen George Grellas.
Caution: Do-it-yourself (“DIY”) Web sites such as LegalZoom and RocketLawyer have been reported to sometimes create flawed documents that might cause significant problems down the road. See, e.g., this Consumer Reports review and this article. I’ve not used either service so I can’t offer a first-hand opinion; I’m also aware that a lawyer commenting about a DIY site is like a photographer commenting about having your friends just take snapshots of your wedding instead of hiring the photographer.
Employment agreement form
See this working draft of a set of model provisions. Suggestions and other feedback are welcome in the comments on that page.
Nondisclosure agreement form
If you’re going to talk to someone about your product or service before you roll it out, you might want to ask them to sign a confidentiality agreement, a.k.a. a non-disclosure agreement or “NDA.”
NOTE: Potential investors might be reluctant to sign an NDA. Venture capitalists in particular often flatly refuse to do so. With folks like that, you basically have to take your chances that they won’t “steal” your idea. As a practical matter, though, that might not be a bad bet, because:
- First, investors and others generally do have one or two other things on their minds. They generally see lots of entrepreneurs who are convinced they’ve got a world-beating idea. You’ll probably be lucky to get these investors to pay attention for two minutes. Ask yourself how likely it is that they’ll want to take your idea and spend time and money building a business around it without you.
- Second, contracts aren’t the only thing that discourage bad behavior. If an investor stole someone’s idea, and word got around, then that investor might later find it hard to get other people to talk to him.
- Finally, you have to decide what risks you want to take. Your business might fail because an investor steals your idea and beats you to market. Or it might fail because you can’t raise the money you need to get started. It’s sort of like having to take a trip across the country. You have to decide whether to fly or drive. Sure, there’s a risk you could die in a plane crash flying from one side of the country to the other. But if you drove the same route, your risk of dying in a car crash has been estimated as being something like 65 times greater. As the old saying goes, you pays your money and you takes your choice.
If you decide you do need a confidentiality agreement, you can consider using an NDA form I posted in 2010.
For some startups this won’t be relevant, but for those who need to have negotiated contracts signed electronically, see this a comparative review of 10 different providers.
Contract negotiation tips for consultants
Here are some basic points to keep in mind.
Before you sign any business contract
See my free e-book explaining things such as:
- How to sign a company contract to avoid inadvertently becoming personally liable
- How to avoid business practices that can land you in jail
- How to spot dangerous clauses that might later be disastrous for your business
Intellectual property tips
IP ownership claims by former employers, etc.
• As an example of how people can come out of the woodwork claiming IP rights, consider famed virtual-reality startup Oculus Rift, now owned by Facebook: A May 2015 lawsuit against Oculus Rift and its founder claims that the founder, in developing the Oculus Rift headset, used confidential information purportedly owned by two guys in Hawaii, in violation of a confidentiality agreement. ADDED July 2016: A federal judge in California teed the case up to be dismissed on summary judgment in January 2017: One of the two guys in Hawaii objected to filing the lawsuit in the first place, and under their partnership agreement, they were both required to agree on such an action. See Total Recall Tech. v. Luckey, No. C 15-02281 (N.D. Cal. June 16, 2016) (granting summary judgment subject to stated conditions).
• A famous earlier example, of course, is the lawsuit by the Winklevoss twins (a.k.a. the Winklevi) claiming that Facebook’s founder Mark Zuckerberg had stolen their idea. The twins reportedly received $65 million to settle the case.
• And then there’s the case of Fitbit, which was sued — as its IPO drew near — for allegedly “poaching” a competitor’s employees and then misappropriating trade secrets of the competitor that the departing employees downloaded and brought with them.
• Ride-sharing network provider Uber was greeted with a lawsuit against the company, its founder, and some of its investors. The lawsuit alleged that Uber had stolen the plaintiff’s alleged trade secrets for a ride-sharing service. See Justin F. McNaughton, Uber’s Birthday: Can Trade Secrets Blow Out The Candles? (Mondaq.com 2015). Evidently there was no written confidentiality agreement, and the plaintiff waited some five years to file suit. A copy of the complaint is here; the plaintiff’s law firm’s Web page about the case is here, complete with a video statement by the plaintiff and a video of the law firm’s press conference.
Due diligence here can be really important. Consider taking some or all of the following steps:
- Check everyone’s previous contracts [employment agreements, severance agreements, consulting agreements, NDAs, etc.]
- Check the facts to see whether an employer might owns someone’s IP work product by default
- Was one of your people previously “hired to invent” or “set to experimenting” by someone else, who might therefore own the rights?
- Was one of your people previously an officer or director of another business, and therefore possibly have a duty to transfer ownership of his or her ideas to the other business?
- Will any of your people be re-using copyrighted work that they previously created “within the scope” of their previous employment, meaning that the former employer might well own the rights?
- Did any of your employees bring a former employer’s confidential information with them?
- Can a waiver of rights be obtained from the former employer?
- Can existing Web content be “re-purposed” for your site? It depends.
- Just because there’s no copyright notice doesn’t mean the content is up for grabs (but a copyright notice is definitely a good idea for your own stuff)
- All kinds of things can be subject to copyright ownership — text, graphics, sounds, videos, sound recordings, data compilations, etc.
- Damages for infringement can include “indirect profits” — MGM Grand Hotel had to pay 2% of its casino profits for unauthorized use of Kismet musical material in its Hallelujah Hollywood floor show.
- Put copyright notices in your code, etc., early — not just in comments, but in “no-op” variables.
- Form: Copyright © [year of first publication] [owner’s name]
- Example: Copyright © 2012 D. C. Toedt III
- Startup company VYNL wanted to be “Netflix for vinyl [records].” They did a Kickstarter campaign. What they apparently hadn’t realized was that renting copyrighted sound recordings (which was at the heart of their revenue model) is a violation of the copyright law. See this writeup.
- If you use a photo you found on the Web in your own Web site, you might get a friendly or unfriendly call asking for payment of a license fee, because photo copyright owners are starting to scan the Web for unauthorized copies of their images. See Joshua J. Kaufman, Busted: Having to Pay the Photography Piper (mondaq.com 2015).
Trademarks— basic considerations
- Check the USPTO.gov Web site, and the Web generally, for possibly conflicting marks. The test is whether a “likelihood of confusion” exists — it doesn’t need to be a certainty of confusion, but it does need to be more than a mere possibility. See this fact sheet by the U.S. Patent and Trademark Office for useful examples and illustrations.
- Consider engaging a professional trademark search firm to clear a mark before making big investments in promoting the mark — you don’t want to have to change the name after you’ve started getting traction, and it might cost a lot of money to pay off a senior user. (On the latter point, Apple found that out the hard way with its Mac trademark.)
- Watch out for possible dilution of others’ trademarks, either by blurring or by tarnishment — see, for example, the Victoria’s Secret example
- Check whether you need to file any assumed-name certificates (a.k.a. DBAs) if you personally or your corporation or LLC is using a name other than its “legal” name.
- Consider filing an “intent to use” federal trademark registration application; see the USPTO fact sheet for details.
Trademarks— look for a “suggestive” one
From both the legal-protection and advertising-value perspectives, it would be nice if your trademark suggested something about your product or service, without describing it. “Suggestive” marks require an imaginative leap to figure out what the mark stands for, but then once you realize what that is, then the mark conveys something about the product or service to the prospective purchaser. See generally this Wikipedia article.
Here are some well-known examples of the different categories of trademark:
Fanciful marks — these are highly protectable legally (at least for the “senior” user, i.e., the one who got there first) because they have no other meaning, but initially they said nothing about the product or service, and so it took some advertising expenditure to establish a consumer meaning. Examples: Reebok; Kodak; Xerox.
Arbitrary marks — also highly protectable legally for the senior user, but they likewise say nothing about the product or service, so initially they don’t do you much good in terms of word-of-mouth advertising value. Examples: Apple (for computers); Blue Diamond (for nuts); Dutch Boy (for paints); Lotus (for software).
Suggestive marks: — arguably this category is the “sweet spot,” combining legal protectability for the senior user with advertising value. (Sometimes, though, it’s a matter of opinion whether a mark is suggestive or descriptive.) Examples: Coppertone for suntan lotion; Greyhound for bus transportation services; Roach Motel for insecticide devices; Kleenex for tissues; Diehard for car batteries; Energizer for consumer batteries; Clapper for remotely-activated electrical switches.
Descriptive marks are harder to protect, but not impossible — the putative owner must show that the mark has acquired a “secondary meaning” in the minds of the relevant public. Examples: Bank of America; Park N Fly; Holiday Inn; Sports Illustrated; Seattle’s Best Coffee; Best Buy.
Generic terms are legally unprotectable — e.g., “vanilla” for ice cream or “pet store” for a pet store.
(Some now-generic terms used to be protected trademarks but became unprotectable when they became the common descriptive name for the product or service, for example, aspirin [in the U.S.], escalator, thermos bottle. That’s why Xerox periodically runs advertisements reminding people that you make Xerox copies, not xeroxes, with their machines.)
Consider filing a provisional patent application, which in essence is a one-year placeholder (with no extensions and no renewals).
A provisional application doesn’t have to conform to formal patent application requirements. It does, though, need to contain an “enabling disclosure.” I sometimes describe enabling disclosure as a hand-off package of written description and drawings that you could give to a competent colleague or team to have them build the invention without “undue” experimentation. (The application must also disclose the best mode subjectively contemplated by the inventor or inventors.)
You can get a head start by doing your own first draft. You can also file a provisional patent application yourself at the USPTO Web site if you prefer not to use a patent attorney. Do that at your own risk, though; it can be useful to have another pair of eyes look at your application.
Watch out for filing deadlines, which are normally drop-dead dates, with no extensions possible. U.S. law provides a one-year grace period in which to file a patent application after the first “disclosure” of the invention. The term “disclosure” has a very specific meaning; see 35 U.S.C. § 102. Most foreign countries are “absolute novelty” jurisdictions for patent filings and have no grace period.
Infringing someone else’s rights
Just because you have a patentable invention, or a copyrightable work of authorship, or a protectable trademark, doesn’t automatically mean you don’t infringe someone else’s pre-existing rights.
For more information about patent infringement, see this 2010 post I did.
Be sure to keep the company’s affairs separate from your personal affairs
Before your company starts actually doing business with others — for example, with suppliers or customers — you should open separate checking- and credit-card accounts for the company; don’t use the company checking account or credit card for personal matters, or vice versa.
From the get-go, keep good business records of revenue and expenditures.
Depending on the type of business entity you form, you might need to keep up with certain required paperwork, for example meeting minutes.
For suggestions along these lines, see generally How to Avoid Personal Liability for Your Corporation’s Actions (Nolo.com).
For a case in which a court found a business owner personally liable, see Doug Batey, Massachusetts Court Pierces the Veil of Single-Member LLC Because of Its Failure to Maintain Business Records (LLCLawMonitor.com 2014).
Laws restricting “exports” of technology
Startups that do any kind of business in other countries should watch out for the laws that govern “exports” of “technology.” Even disclosing certain categories of information to non-U.S. nationals can constitute an “export” that can lead to fines and/or imprisonment. Harvard University’s Web site contains a useful slide-deck primer on the subject (apparently from the Smithsonian Institution); another informative slide deck is at the Washington State University site.
The export-control laws are typically (but not exclusively) a concern with regard to encryption technology. For information on encryption exports, see, for example:
- this understandable Microsoft explanation concerning what it takes to qualify to sell at app at Microsoft’s app store;
- this U.S. Government FAQ document about encryption;
- this FAQ about what constitutes an “encryption item.”
Artificial intelligence (“AI”) is also subject to the export-controls rules; this will be of particular interest to some of the hot new big-data startup companies.
Web site accessibility under the ADA
Advocates for the disabled are trying to use the Americans with Disabilities Act (ADA) to force Web sites to comply with accessibility rules. In November 2014 the U.S. Department of Justice entered into a settlement agreement with Internet grocery delivery service Peapod, requiring Peapod to take specific steps to remedy alleged violations of the ADA.
For more information, see generally:
- How to Prepare for Web Accessibility Before the Government Forces Your Hand (CIO.com 2013): This article presents a readable overview, with extensive links to checklists, etc.
- Creating an ADA-compliant Website (TechRepublic.com 2012))
Taking credit-card information
If you’ll be taking and/or storing credit-card information, you’ll need to be aware of the Payment Card Industry Data Security Standards (“PCI-DSS”). Violation of those standards can get you in trouble with Visa, Master Card, etc., and possibly under state law; on the other hand compliance with the standards might provide some legal protection under state law. See the Wikipedia article as well as these tips from Hacker News commenter ‘tzs.
Foreign investors – or foreign investment?
If foreign investors own 10% or more of your U.S. business (or if your company owns 10% or more of a foreign business), you might have to file reports with the U.S. Department of Commerce. See generally Robert Soza and Carlos Treviño, Mandatory BEA Filings: Have You Complied? (JW.com March 2016).
What business form – LLC or corporation?
Overview: A general rule of thumb
I often get questions whether a startup should form an LLC or a corporation, or neither. My own rule of thumb (which might not be valid for all companies in all situations) is as follows, for reasons discussed in more detail in the ensuring sections:
- If your product or service likely won’t create any risk of economic- or physical harm to others — and thus there’s comparatively little risk of your being held liable for such harm — then you might be OK remaining in the “default mode,” which is a sole proprietorship (if it’s just one person) or a partnership (if more than one person). By going with the default mode, you’re accepting the theoretical risk of personal liability in exchange for fewer paperwork requirements. EXAMPLE: So far I’ve kept my Common Draft working notebook of contract clauses as a sole proprietorship, for just those reasons; if/when I get to the point of trying to monetize my work, I’ll revisit the question.
- On the other hand, if your product or service might create some risk of economic- or physical harm to others, then you’ll want to think about forming either (i) a limited-liability company (“LLC”) or (ii) a corporation. With those business forms, you accept the modest burden of additional paperwork in order to get legal protection from personal liability — protection that is not totally impenetrable, by the way. (For clarity: The legal protection wouldn’t keep you from losing your entire investment in the company if the company were to be held liable for harm to others.)
- If you expect to take outside investment, and/or to grant equity to employees, contractors, etc., then a corporation will often be the simplest way to go in terms of paperwork burden and tax pitfalls.
- If you plan to run your startup as a lifestyle business, then an LLC might well be the business form of choice — but you might be setting yourself up:
- to have to pay personal state income tax in states where your LLC does business, and/or
- to pay the federal Medicare tax on 100% of your share of your LLC’s business profits and not just on your reasonable salary from the LLC.
The sole proprietorship is the “default” mode for someone doing business alone. Not many startup founders will want to stay a sole proprietorship, though, because of the unlimited personal liability, as discussed below.
- No formal filing is needed (except a DBA filing if doing business under another name)
- Income-tax filing is simple — it’s done on Schedule C of the regular Form 1040.
- It’s very advisable to get a separate federal employer tax ID number from the IRS (you don’t want to use your personal Social Security number).
- Sole proprietors have unlimited personal liability for debts incurred and damage caused by their businesses.
- Investors are highly unlikely to invest in a sole proprietorship in any way that the sole proprietor would likely find acceptable.
Limited liability company (LLC)
Limited liability companies require very little paperwork and by default do not pay federal income tax. As a result, LLCs are popular with the owners of “lifestyle” businesses who hope to take cash out of the business and don’t expect to take investment or to achieve unicorn-style growth.
But LLCs are generally not regarded as good vehicles for taking investment, because they have some significant disadvantages under federal tax laws and some state laws.
Some points to keep in mind:
- An LLC has no legal existence until a “certificate of formation” is filed with the Texas Secretary of State – this can be done online.
- An official filing fee is required; the amount of the fee is $300 at this writing.
- LLC members have limited liability for the LLC’s debts and liabilities – but many suppliers, landlords, etc., likely will want personal guaranties from some or all members.
- An LLC must get a federal employer tax ID number from the IRS.
- Income-tax status for single-member LLCs is “pass-through,” meaning that the LLC doesn’t have to pay taxes, because all tax liability is passed through to the LLC’s members. (Multi-member LLCs can elect “corporate” status elected by filing an election document with the IRS.)
- Investment in a single-member LLC is highly unlikely (and almost a contradiction in terms).
- If you form a multi-member LLC, you’ll definitely want an “operating agreement” (known in Texas as a “company agreement”). See generally, e.g., David M. Waizer, The Top Three Provisions for Every LLC Operating Agreement (2018).
- Investment in a multi-member LLC can be complicated and expensive to document; many investors will want to invest in a corporation instead.
Some commentators think startups should never form LLCs; see, e.g., Joe Wallin, 12 reasons for a startup not to be an LLC (Sept. 2011). He concludes with:
The bogeyman that you will hear about most frequently is the “double tax” bogeyman. You will be told—don’t form a C Corporation because you will be subject to a double tax.
What is meant by this is that if the C Corporation makes money, it will pay tax on that money. And if it pays dividends to its shareholders, they will pay tax on the dividends. This is true.
And so if you anticipate your business being a cash cow, and immediately generating so much money that you will earn more than you can reasonably pay out in salary to the owner executives, then maybe an LLC is a good choice for you.
But for most growth businesses, whose goal is to raise capital, reinvest capital, grow fast, grant equity incentives, and ultimately be acquired or go public, a C Corporation is the way to go.
For these businesses, the double tax bogeyman rarely appears, and most exits are structured as one layer of tax [sic; tax-free?] stock sales.
(Extra paragraphing added.)
Others think an LLC is fine to start out with, as long as you accept that you’ll likely have to convert to a C corporation if you want to take investment.
(I tend to agree with Wallin.)
By default, any business with multiple co-founders will usually be a general partnership. This can work OK in the early stages of preparing to start a business. But operating as a general partnership will usually be a Bad Thing once the company has launched a product or service that has any appreciable risk of significant liability.
- Under the law in Texas (and numerous other jurisdictions), a general partnership comes into being automatically, with no filings, any time that two or more “persons” (individuals or organizations) associate to carry on a business for profit as owners; this is true whether or not the persons intend to create a partnership and whether or not the association is called a partnership, a joint venture, or some other name.
- No filing is needed (except a “DBA” filing if an assumed name will be used)
- Partners in a general partnership have unlimited, joint-and-several liability for the partnership’s debts and liabilities.
- A partnership must obtain a federal employer tax ID number from the IRS.
- For federal income-tax purposes, partnerships are pass-through entities.
- Investment in a general partnership is unlikely (a limited partnership is another story.): Unlikely (investors would usually demand limited partnership)
The gold standard for startups that hope to take investment is the C corporation.
- “S” corporation and “C” corporation refer to a corporation’s tax status, specifically, to Subchapters S and C of Chapter 1 of the Internal Revenue Code. (Corporation law as such generally doesn’t distinguish between S corporations and C corporations; those designations matter almost exclusively for federal income-tax purposes only.)
- A corporation doesn’t exist until a certificate of formation is filed with the Texas Secretary of State; see the discussion of LLCs.
- For tax purposes, corporations are treated as “C” corporations unless and until they file an election document with the IRS.
- To qualify for “S” corporation tax treatment, a corporation must have fewer than 100 shareholders and cannot have “non-resident” foreigners as shareholders.
- A corporation must get a federal employer tax ID number from the IRS.
- “S” corporations are “pass-through” entities for tax purposes (like a single-member LLC); their earnings are not taxed at the corporate level, but only after being distributed to shareholders.
- “C” corporations are taxable entities whose net earnings — if any — are taxed twice: Once at the corporate level, and again when distributed as dividends to shareholder. (But that might not be an issue for startups that don’t expect to have net earnings for awhile.)
- Corporate shareholders have limited personal liability.
- You might be able to exclude up to $10 million in capital gains from federal income taxes (post-exit) by structuring the corporation to meet the requirements for “Qualified Small Business Stock.”
For a variety of opinions on incorporation, see the Hacker News thread, Should I incorporate my business?
If you change your form of business (e.g., if you start out as a sole proprietorship but later incorporate), be sure to check whether your business-insurance policies need to be updated. Otherwise you might end up having to fight with your insurance carrier over whether you’re still covered. This happened to a small business owner in Christy v. Travelers Indemn. Co., No. 14-2168 (10th Cir. Jan. 20, 2016) (reversing and remanding summary judgment of no coverage).
As mentioned briefly above, if you create an LLC, or a corporation that qualifies to be taxed under subchapter S of the (U.S.) Internal Revenue Code, you’ll need to decide whether, for tax purposes, the company’s income and losses are going to be passed through to its members (the default for LLCs, like a partnership) or whether instead you want to file an election to have the company taxed as a C or S corporation. This is something to discuss with someone who knows tax law.
I found a Nolo article that looks quite useful in discussing the pros and cons of various approaches: http://www.nolo.com/legal-encyclopedia/how-llcs-are-taxed-29675.html.
Employer identification number (EIN)
The company will need to get a federal tax ID. If the company applies for bank financing, or even to open a checking account, the bank will almost certainly require the company to provide a tax ID. You can get a tax ID, or “EIN,” on-line at https://sa2.www4.irs.gov/modiein/individual/index.jsp.
Unemployment tax registration
(For Texas companies, and probably for other states as well:) When you hire your first employee, you’ll need to register with the Texas Workforce Commission and make quarterly unemployment tax payments. See http://www.twc.state.tx.us/ui/tax/unemployment-tax-registration.html and https://portal.cs.oag.state.tx.us/wps/portal/employer.
When you’re ready to start making sales, you’ll need a sales-tax permit. You can get one on-line at http://www.window.state.tx.us/taxpermit/.
Employee tax withholding
The IRS is pretty fierce about the need for employers to withhold (and remit) employees’ income taxes, Social Security taxes, and Medicare taxes.
In some circumstances an officer, director, or manager could be personally liable for a company’s failure to withhold the required taxes, and possibly for up to a 100% noncompliance penalty. That happened to a Michigan small-business executive who discovered that his business partner, the company’s controller, had been stiffing the government of withholding payments. See United States v. Hartman, No. 17-2273 (6th Cir. July 25, 2018) (affirming summary judgment in favor of government).
- http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Employment-Taxes-2 for more information;
- this story about a startup that had “withheld” payroll taxes for nearly three years, but hadn’t sent them in to the IRS — after penalties, interest, and legal fees, this ended up being about a $500K mistake; and
- this story about a business owner who was sentenced to three years in prison for withholding some $12 million from employees but then not paying it to the IRS, instead using the money to make payments on his ranch and to travel to Las Vegas, Hawaii and France. (He also failed to pay the IRS around $6 million that his company owed.)
State franchise taxes
Check your state’s requirements for filing franchise tax reports and payments.
Also, if you’re doing business in other states, check the requirements of those states. You might have to officially qualify to do business there and pay franchise taxes, income taxes, sales taxes, or all of the above.
IMPORTANT: An immediate 83(b) election might be necessary
If your stock will vest over time (as is typical for founders of funded startups), it might well be critical for you to file an “83(b) election” with the IRS promptly after you receive the grant. Otherwise, you might end up liable for huge income taxes on “phantom income.” For more details, see, e.g.:
- 83(b) election for dummies (AccounTalent.com)
- What is a Section 83(b) Election and Why Should You File One? (CooleyGO.com)
- What Is An 83(b) Election and When Do I Make It? [Part 1 – With Graphic!] (AcceleratedVesting.com)
End your fiscal year on January 31 instead of December 31?
Check with your accountant about imitating Salesforce.com and ending your fiscal year on January 31 instead of the usual December 31, for the reasons discussed in this Forbes article, including:
- A January year end can help relieve pressure from customers to give deep discounts as December draws to a close.
- Many customers’ annual budget dollars will be exhausted in December but will be replenished in January.
- Customers’ decision makers and support staff (legal, finance) will have more available bandwidth in January than in December.
- Your sales staff can enjoy the holidays and come back refreshed to close out your fiscal year with renewed energy.
Working with lawyers
How to get your money’s worth from your startup lawyer and the associated Hacker News discussion.
General business reading for startups
Things learned while running your own self-funded startup (a list of 25 specific points), as well as the Hacker News discussion (of course).
- 62 (employment matters)
- 96 (marketing)
- 104 (trade secrets)
- 122 (trademarks)
- 167 (litigation and other disputes)
- 190 (emails)
- Tax-Free Founder Stock
- This short guide and the comments by HN’s resident legal maven George Grellas and others.
- What I Wish I’d Known About Equity Before Joining a Unicorn (anonymous) and the HN comments.
When a customer asks for a steep discount
Also, this hilarious video:
The dangers of landing a big customer
To take investment, or not?
Not all investors will be good allies; see this Hacker News comment thread for tales of founders who regretted taking investment.
An excellent book by venture capitalist Brad Feld and startup lawyer Jason Mendelson is Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. (A newer edition is scheduled for release in August 2019.)
Demo days can be dangerous places to start raising money
Safes as a very-early investment vehicle
Y Combinator has developed “safes,” which stands for Simple Agreement for Future Equity, as a low-cost vehicle for taking very-early investment. (A startup would still have to be sure that any sale of a safe to an investor qualified for an exemption under state and federal securities laws; be sure to check with your lawyer.) See generally:
- the announcement of safes, together with the ensuring Hacker News discussion, especially the top-of-page comment by George Grellas, a Silicon Valley startup lawyer who’s highly regarded by the Hacker News community;
- an article about L.A.-area use of safes, along with HN discussion;
- a critique of safes by venture capitalist Mark Suster and the ensuing HN discussion, again especially including George Grellas’s comments;
- another critique of convertible notes (and this follow-on post about convertible notes and safes, with HN discussion) by venture capitalist Fred Wilson;
- a story by Alex Iskold about how, when a TechStars NYC portfolio company was acquired, the founders were seriously diluted because the company had raised four rounds of convertible debt, but none of the debt was ever converted to equity, and none of the debt was ever diluted as successive debt was layered on top;
- a law professor’s report on a 2018 survey gauging lawyers’ familiarity with safes.
At some point, most businesses will want to start paying for insurance of various kinds. See generally:
- The Types of Insurance You Need for Your New Business (Entrepreneur.com 2015)
- My insurance-basic posts
Serial entrepreneur turned venture capitalist Mark Suster has some tips on avoiding lawsuits.
Disgruntled employees are a main source of lawsuits for companies. These useful practices for avoiding employee lawsuits are worth reading.
Bank loan covenants
Injury- and illness prevention
Under the California version of the Occupational Safety and Health Act (OSHA), all employers with establishments in California must have injury- and illness prevention programs, regardless of company size or industry, as attorneys from the well-known employment law firm Seyfarth Shaw remind us.
There’s a good discussion at Hacker News about getting paid by enterprise customers. (Hint: it likely will take awhile, so plan accordingly.)
• Take a look at the recommendations posted on this Hacker News thread.
• Hacker News discussion on what credit card to use (hint: get a separate business credit card to make it easier to segregate tax-deductible business expenses from personal expenses).
See the “cheat sheet” at If I launched a startup, and the resulting comment thread at Hacker News, especially the comments by @grellas (an experienced and highly-regarded Silicon Valley startup lawyer — see this list of @grellas’s best comments) and @tptacek (an experienced tech entrepreneur).
Another useful resource: The startup law glossary, with some 500 entries at this writing.
Another Y Combinator co-founder, Jessica Livingston (she and Paul Graham are married) has an article on Sales 101 for startups that summarizes what seems to be evolving into a consensus view: She says, “[a]t Y Combinator, we advise most startups to begin by seeking out some core group of early adopters and then engaging with individual users to convince them to sign up”; she illustrates the point with real-life stories. She concludes, “Our advice at Y Combinator is always to make a really good product and go out and get users manually. The two work hand-in-hand: you need to talk individually to early adopters to make a really good product.” The comments on the article at the Hacker News forum are also informative.
Would-be entrepreneurs should also read the writings of Patrick McKenzie, a.k.a. patio11, on his Web site and in his comments at the invaluable Hacker News site (where at this writing he is #2 on the all-time karma list). Two especially-good comments for beginners are here and here.
Dropbox founder Drew Houston has posted notes on How do I find good technical co-founder?; see also The Answer to the Eternal Question: Where do I Find a Technical Cofounder? and the Hacker News comments to it.
A woman-oriented startup site is Hello Alice.
If you’re in the Houston area, you should definitely check out the Houston Lean Startup Circle.
See this thought-provoking Hacker News discussion.
Selling the company
Most experienced entrepreneurs advise not thinking about selling the company. But if you do, consider the following:
- Paul Graham, Don’t Talk to Corp Dev (about the dangers of entering into discussions about selling the company)
- Justin Kan, The Founder’s Guide to Selling Your Company (apparently recommended by Paul Graham for when it’s time to sell) and the Hacker News discussion
- Tyler Tringas’s long report on Selling My Bootstrapped SaaS Business and the Hacker News commentary.
How do I know when my startup has failed?
A bunch of Hacker News participants offered comments on that subject.
Leaving the company as a co-founder
• An interesting Hacker News discussion: Ask HN: Leaving as founder, what happens with equity?. (Note that lots of the commenters say, in effect, I’m not a lawyer, be sure to talk to one.)
• And another one: Ask HN: How best to break up with cofounder?