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Ask the Experts – Part 2: Stock compensation, valuation, employee vs contractor and other intricacies of being a start-up

In Ask the Experts – Getting Started we addressed the common start-up questions of choice of entity, when to talk to VC’s and whether you should pay yourself a salary. Now let’s focus on some of the issues that come up as your business progresses.

What do I need to know about stock compensation?

We understand that you are anxious to reward the people who have been with you from the beginning and to have some “currency” with which to lure the next round of new hires.  But we recommend proceeding carefully when you start to issue any form of stock compensation.  First, don’t make vague promises.  We have seen too many situations where founders promised certain things to employees but never followed through with clear definitive agreements documenting the arrangement.  In at least one case, the situation ended in litigation as the company was attempting to do an IPO.  Next, in order to issue most forms of stock compensation, you will need to know or at least be able to estimate the fair value of your company.  A misstep here can result in a nasty tax surprise to your employee, turning what was supposed to be an employee benefit into a potentially big problem.  Lastly, issue restricted stock thoughtfully.  Make sure you understand what the tax implications will be to the recipient but also give careful consideration as to whether you actually want this person as a shareholder of your company for the long-term.  It’s important to have the appropriate legal documents and provisions in place, for example, the right to repurchase the share upon future termination.  As with most important initiatives, you should work closely with your attorney before issuing any stock compensation.

What are some of common tax and accounting pitfalls I should avoid during this early phase?

Income Tax – yes, even you and your little company have income tax filing requirement.  Some entrepreneurs think that if they are small, with no revenue and only losses to report that there isn’t a requirement to go through the formal process of filing a tax return.  Unfortunately, the IRS doesn’t see it that way.  Once you have a legal entity established and have any activities in that entity, you probably have an income tax filing requirement (federal and state).  You might think this is something that can be put off and you’ll “catch-up” later on when your activities are more significant, but it has been our experience that it always ends up being more costly and less efficient to do it this way.  Finally, even though those first years’ tax returns will be pretty straight forward, there are a number of choices you need to make that can have significant consequences down the road.  It’s always best to start off on the right track when you’re talking about income taxes.

Books and records – get your bookkeeping off on the right foot.  At the earliest stages, this task is probably going to fall to one of the founders since it doesn’t make sense to outsource it.  You don’t have to get fancy but you should get yourself signed up for Quickbooks Online.  It’s not the world’s greatest accounting package but it will certainly do everything you need it to do and more.  But it is also relatively easy to use, the founders of the company sitting next to you are probably using it to so you can share tips and finally, when the time comes to outsource the bookkeeping function, Quicken will put you in the best position to facilitate this transition.  Beyond the bookkeeping, be sure to also retain copies of important records at this stage – bank statements, credit card statements, contracts, invoices, etc.  Document storage these days is so cheap, or even free, that there is no reason not to have complete records stored online.  You will need them some day.

Separating personal and business activities – we understand that early on, it is sometimes difficult to distinguish between the two, especially if you’re a single founder.  But do the best you can not to commingle your personal financial life with your businesses.  Try not to use personal credit cards for business expenses, don’t pay your apartment cable bill out of the business thinking you can “deduct” it and don’t deposit checks received for business consulting work into your personal bank account.   

Investors are knocking, is now the right time?

Although most founders struggle mightily to raise every dollar of capital, there are some founders who have the opposite problem.  Everyone who hears their pitch seems to want to give them money and this can raise its own set of challenges.  If you are lucky enough to find yourself in this situation, you should ask yourself the following questions:

Do you actually need the money?  This may sound obvious but some business are not very capital intensive and can get fairly significant traction without raising much money.  What would this investment allow you to do right now that you can’t currently do?

If you decide you could really put the money to good use, how much should you raise?  This is a real balancing act.  On the one hand, it’s hard to have too much money on hand.  On the other, each dollar raised is being “paid for” with equity out of your pockets.  So at this point when the company’s valuation is low, you want to raise only enough money to get your company to the next valuation point.

Do you actually want this person as a shareholder?  This can be a sensitive issue, especially when dealing with friends and family members.  Uncle Bob may be delightful for a few hours around the Thanksgiving dinner table but will he be a good shareholder in your company for the long-term? 

What’s my business worth?  This can be a very difficult question at these early-stages.  Set the price too low and you end up giving away too much of your business.  Set the price too high and it can make future fundraising more difficult.  And if you are dealing with unsophisticated investors, it is just as likely that you will end up setting the price too high as it is setting it too low.  When you go to raise your next round of financing with professional investors, this early overvaluation issue will need to be essentially corrected.  That correction will come in the form of financial pain (i.e. dilution) to those early investors potentially causing hard feelings with your friends and family.

Having to turn down interested investors might be one of the hardest things an early-stage founder will do.  But the problems that come from taking the wrong amount of money, at the wrong time, from the wrong people can be even harder.

It has been difficult to agree with investors on a valuation, what options are there? 

VC’s see startups from a pragmatic point of view. For every one that succeeds, many more fails and they know that in order to deliver adequate returns to their investors, they cannot overpay for early-stage companies. In fact, in our experience the range of values assigned to truly early-stage companies is pretty narrow.  This often means that the VC will assign a pre-money value to your business that is less than you believe your business is worth. Of course valuation is important if you’re a founder since it ties directly to dilution.  But founders shouldn’t focus solely on valuation when negotiating with VC’s.  Look closely at the proposed terms of the preferred stock being proposed since not all preferred stock is created equally.  Are the investors entitled to dividends?  Do they participate above and beyond their original preference plus dividends. Another area for negotiating is the size of the option pool that will be put in place in conjunction with the financing.  This is important because the shares in this option pool will come out of the founders’ ownership interest.  A willingness to get beyond simply the valuation and look at the terms that are being offered overall, you are much more likely be able to strike a deal that works for both sides.

I've got a software development background so I know everything I need to know about information security, right?

In short, we find the answer to be “No.” As a start-up, your company has the singular purpose of developing a software or application for functionality, often with little consideration for data security protocols. Unless security considerations are a topic of discussion early in the product development most developers will not consider lock-out parameters, password complexity, and multi-factor authentication into the initial design and functionality of the software or application. Given the use of SaaS and the cybersecurity environment, security standards are moving to more complexity, not less. Have discussions with technology security experts related to information security, SOC reports, or PCI compliance early or you run the risk of having to reverse engineering it down the road with significant cost and lost time being the result.

My founders team and/or development team is spread across the country. What do I need to know?

With team members being spread out across the country, that can mean state and local tax issues. A physical presence will subject you to state taxation so register your company to do business in the relevant states. Next, make sure that you're set up to collect and remit income tax, sales tax and payroll tax in all of the states involved. Otherwise, you could face penalties and unwelcome questions during an exit. If you plan to operate internationally, also make sure you're aware of the international tax implications before you start doing business. As complex as the multi-state rules are, the international rules are even more complex and there are a lot of alternative structures that can be employed.

Should I go with employees or contractors?

Most importantly, an entrepreneur needs to understand that they don’t get to choose whether someone is an employee or an independent contract.  That distinction is determined by the nature of the relationship between the two parties.  The distinction is important because if someone is determined to be an employee of your company, you have a number of important legal responsibilities with respect to that person, not least the obligation to withhold and remit payroll taxes on their behalf.  To determine if someone is an employee, you need to look at the level of control and independence that exists in the relationships.  Some questions to ask your – do you control when and where the work takes place?  Do you provide equipment to use?  Do you determine which tasks should be performed by which individual?  Do you reimburse them for expenses?  Is the person performing services for companies other than yours?  Is the person eligible for any benefits, like paid time off?  Is the relationship expected to have a limited duration or is it indefinite?  There are no “hard-and-fast” rules here so you need to be careful.  We understand that entrepreneurs want to keep things as simple as possible in the early phases and contractors will always be easier than employees but if you are found to have inappropriately misclassified employees your life will be anything but easy!