Capital Matters

Legal and Financial Structure of Tech Startups

John Gillingham ACCY 299 Instructor: Dr. Hugh Pforsich June 2011

What is a “tech” startup?

• • • • This presentation will focus on businesses that share the following general characteristics: A technological focus, primarily software or internet based Low relative barriers to entry Initial staff less than 100 employees “Grassroots” start, not initially a subsidiary

Business Structure Should Facilitate Startup Goals:

• • • • • Intellectual property development “Free” user accounts which may provide current or future revenue Paid user accounts for services, software, etc… Funding for business development Structure which allows for efficient acquisition.

What about profit?

• • • Technology ventures can be very unprofitable in the short term.

Traditional metrics such as net income, balance sheet strength, and increasing profits may be less important than in traditional industries.

Investors likely looking for high rate of return by ultimately selling a portion of the business.

Capital Needs

• • • • Needs for capital may be very high due to many years with no paper profits Entrepreneurs want as much capital for as little cost as possible Business structure must take into account the needs of investors An investment – centric business structure should ultimately reduce the costs of capital

What do Investors want?

• • Rational investors want to maximize return and limit risk The business has a motivation for an investment – centric structure for the mutual benefit of both entrepreneur(s) and investor(s)

Maximizing returns

• The idea. The startup clearly have a compelling concept, experience, and possibly revenue.

• Factors which can help maximize profit: -Minimizing taxes increases net after-tax proceeds -Shares, units, or ownership should be easily transferable -Administrative costs as less as possible

Minimizing risk

• Risk should be limited to capital invested -Legal structure and Insurance • • -Accurate financial record keeping and preventative measures against defalcation Internal and external audit if cost-benefit constraints are met Startups have higher inherent risk which may exclude them from typical financing (i.e. banks)

Limiting liability

• • • Business structures such as: C-Corporation (C Corp), Limited Liability Company (LLC), and S Corporation offer liability protection with various advantages and disadvantages.

Insurance can help protect against lawsuits in which business owners may be personally liable.

Insurance also may help protect the business against catastrophic risks beyond the control of the business structure.

C-Corporation

• • • • • •

Advantages

Qualified small business stock may increase net returns for investors and capital to the business Shares easily transferable Public company structure Ease of ownership for other structures such as trusts Different share classes 83B non-stat. stock options • • • • •

Disadvantages

Corporate tax Taxation of dividends (Code Secs. 11 301(c) Additional compliance costs Division of profits complicated by corporate governance and structure Share dilution possible

Qualified Small Business Stock – (QSBS)

• • •

Advantages

Section 1202 exclusion can limit capital gains on stock from 50% to 100%, subject to other limitations.

Tax-free rollover can be accomplished If stock becomes worthless, $50,000 to $100,000 may be deducted against ordinary income.

• •

Disadvantages

Must have less than less than 50 Million in assets Typical double taxation on profits and compliance costs like any corporation

S-Corporation

• • • •

Advantages

Flow-through structure may provide passive losses or gains for investors to offset other passive income and loss.

No double taxation issues Relatively easy conversion to C-Corporation May pay have profits not subject to SE tax • • • • •

Disadvantages

Shareholder entities must be limited Limits on investor quantity Only one share class allowed Ownership restrictions for foreigners Strict profit and loss ownership based on stock ownership %

Limited Liability Company (LLC)

• • •

Advantages

Flow-through structure may provide passive losses or gains for investors to offset other passive income and loss Limited liability No double taxation to shareholders • • •

Disadvantages

LLC must give “units” instead of stock options to employees Subject to passive loss rules Must change entity before SEC filing (Soh)

How are startups funded?

• • • “Those with high intangibles such as trademarks have a higher probability of funding through external equity from angel and venture capital (Samyal, Mann)” Banking institutions less likely to extend loans to intangible assets.

The “lean startup” can often get going with seed capital from credit cards and family (Blank, Steve)

Interview: JT Forbus Firm: Bogdan & Frasco, San Francisco, CA

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Role: Tax and Accounting

JT Forbus is primarily a tax and general ledger accountant. He notes that owners of tech startups are generally disinterested in the tax and accounting of the business.

Founders tend to neglect the accounting function to save money and dedicate time to other forms of business development.

Often times founders end up in CFO or other executive roles that they are not qualified for.

• • • • Entity choice often dictated by attorney Legal reasons for structure is the primary consideration Startups generally have poor accounting controls Accounting firm often takes the role of bookkeeping Additional funding usually in exchange for equity

Lecture: Steve Black “Why Accountants Don’t Run Startups” Role: Tech guru and Stanford instructor

21 years and eight startups, Steve Blank noticed reoccurring patterns and has written “The Four Steps To An Epiphany” and “Not All Those Who Wander Are Lost”. He is very critical of the traditional business plan and corporate emphasis on profitability.

Venture capital is known as “risk capital.” Without this risk capital there would be little to no development. • • • • • • Now:“500k is the new 5mil” Startups should not have a business plan Emphasis on intellectual property development, not annual revenue Startups should view advisors with healthy skepticism 150 people = “you are a company” Metrics versus accounting

Lecture: Organization: Girls in Tech, San Francisco, CA Role: Startup support group

Girls in Tech provides a forum primarily for women to grow in the tech field. One member of the senior panel is also actively involved in funding startups in unique ways.

• • • • Business structure much less important than in the past Startups have several outlets for mentoring such as groups or prior founders Prior founders supportive of cultivating business environment New environments facilitate idea exchange, such as: The Summit SF

The Summit SF Role: Café and work environment

The summit SF is a café that also provides a unique working environment for startups. • • • Supportive environment for tech entrepreneurs, mentoring and funding Every four months the owners fund a startup with $25,000 and use of space in exchange for 8% of common stock Unique setup displaces traditional business structure and support environment

Interview: Alex Dore Role: Software Architect

Alex Alcantari has an extensive technology background, generally for larger corporations. Unlike the lean startup model, he believes that projects must be orchestrated from a management level to achieve long term success. • • • • • Believes that project manager should also be cost sensitive Startups fail 99% of the time Tech entrepreneurs are “Rockstars” Poor management will sink any business rapidly Often VCs are prior tech engineers

Sources

Apple Logo: http://venturebeat.com/2009/01/21/record-revenue-and-earnings-for-apple-on-huge-ipod sales-but-iphone-sales-miss-expectations/ The Atlantic: Let's Just Make the Startup-Coffee Shop Thing Official – 2/23/11 http://www.theatlantic.com/technology/archive/2011/02/lets-just-make-the-startup-coffee shop-thing-official/71603/ Facebook Logo: http://www.facebook.com/ Forbus, JT, Interview: 6/13/2011, Financial District, San Francisco CA Girls in tech, SF Host Digital Media Lecture: 6/17/11, Financial District, San Francisco CA Google Logo: http://www.google.com/ Blank, Steve, Lecture: 4/15/2010: “Why accountants don’t run startups” http://www.justin.tv/startuplessonslearned/b/262670582 Blank, Steve photo: http://www.kfinn.com/2011/03/steve-blank-on-start-ups-vs-large corporations/

Sources

Band of Angels: http://bandangels.com/ Chevron Tower photo: http://www.aviewoncities.com/buildings/sf/chevrontower.htm

Dore, Alexander, Interview: 6/19/2011, Mission District, San Francisco CA Sanyal, Paroma, Mann and Mann, Catherine : Asset Specificity, Information Asymmetry and New Firm Financing* http://sites.kauffman.org/efic/conference/Sanyal_Mann.pdf

Soh, Peter: “Top ten Planning techniques for startups” http://www.adviseinc.com/resources/articles_Top10TaxPlanningStartups.html

South Coast Angels: http://southcoastangelfund.com/angel-capital-association/ Swanson, Jim: “Los Altos Incubator, Internet specialists on the web since 1994” http://firstonline.com/