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 (CCorp), Limited Liability Company (LLC), and SCorporation 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
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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
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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
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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
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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
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-ipodsales-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-coffeeshop-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-largecorporations/
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/