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(Editor’s note: Doug Collom is vice dean and an adjunct lecturer on venture capital and entrepreneurship for Wharton|San Francisco. He submitted this story to VentureBeat.)
Starting companies is hard. And it’s critical to make sure that your venture is pointing in the right direction from the moment it leaves the launch pad. Any misdirection or miscue on the basic organizational steps can be fatal.
It’s a lot like launching a rocket aimed at the moon—if the launch is only 2 degrees off target at blast-off, it will miss by hundreds of thousands of miles.
There’s no end to the advice and opinions entrepreneurs will hear in a company’s early days, but three basic rules that every company founder should take into consideration:
Keep it simple – In setting up the capital structure and the first equity of the company, many founders either try to innovate or try to accommodate the wishes and desires of every co-founder and early stage employee. The result is too much complexity.
In most cases where there is more than one founder (probably on the order of over 80 percent of startups), the stock should be split equally. If it isn’t an even split, then you should re-evaluate whether your co-participants really deserve to be in the “founder” category. Establish uniform stock vesting provisions that apply equally to both founders (although maybe with some “credit” for pre-formation activities) and early stage employees.
Stay away from unconventional employment terms that differ from founder-to-founder or employee-to-employee. And make sure and outside board members (including, if you have one, your advisory board), are compensated equally.
If you fail to keep the capital structure and the equity incentive arrangements absolutely consistent with convention, then every investor you approach and every manager you hire will require an explanation. Stay focused on the business plan, not the infrastructure of the company.
Select your business entity wisely – If you are planning on raising professional capital, whether from an angel group or from a venture capital firm, use a Subchapter C corporation incorporated in the state of Delaware.
LLCs simply do not work. Investors categorically will not put money into an entity that will require them to file annual federal and state tax returns to reflect the pass-through of operating gains and losses (as LLC’s do).
Subchapter S corporations are also a poor choice if the fundraising process is likely to begin in the first year. Sub S companies are viable only with investors who are “natural persons” (which automatically is a problem with VC firms and most angel groups) and only where there is a single class of stock (i.e., not preferred stock, which is typically the class of stock given out to angels and VCs).
A Delaware corporation is the preferred choice among states to choose from—most law firms will recommend this for a number of reasons, not the least of which it will save you the expense of reincorporating to Delaware in the event you are successful enough to consider an IPO in some distant future. (Fun fact: some 70 percent of the US publicly held companies today are incorporated in Delaware.)
Wait until the time is right before forming your company – Many founders are in a rush to go out and incorporate and set up the founders’ stock arrangements and stock plan. WAIT.
It doesn’t take much time to form and organize a company—with three general exceptions:
- You have promised your co-founders and/or anticipated early stage employees specific allocations of stock, and they are tired of waiting to get their hands on the stock certificates.
- You are about to enter into a contract with a strategic partner or a significant vendor or a major customer, and either they want to see a corporate entity on the signature line, or you are worried about potential personal liability if you sign as an individual.
- You are highly confident you are going to get funded.
Absent these circumstances, focus on the business.
Of course, there are many other matters that need to be addressed almost daily by any founder, but these three rules are likely to save you a lot of aggravation later on. More importantly, they will enable you to keep your focus where it belongs—on your business plan and persuading the investment community to see the potential in your company that you see.