Key Moments
Carolynn Levy And Panel (Jon Levy, Jason Kwon) - Startup Legal Mechanics
Y CombinatorKey Moments
Understand startup legal mechanics: incorporate, issue founder stock, use online platforms, and avoid common pitfalls.
Key Insights
Form a separate legal entity, preferably in Delaware, using online platforms like Clerke or Stripe Atlas for efficient incorporation and post-incorporation support.
Founder stock should be issued with a stock purchase agreement, be subject to vesting, and documented meticulously in a cap table.
Treat the corporation as a separate entity by opening a bank account, paying taxes, and maintaining organized legal documents.
Avoid common mistakes such as delaying incorporation, choosing an LLC over a corporation for fundraising, not reading legal documents, and paying employees solely with stock.
Understanding the nuances of employment agreements, IP assignment (CI IA/PI IA), and the 83-b election is crucial for founders.
While online tools are effective for early stages, engage traditional legal counsel for complex issues, significant fundraising, or specialized areas like immigration or international expansion.
THE IMPORTANCE OF INCORPORATION AND DELAWARE AS A CHOICE
The foundational step for any startup is forming a separate legal entity. This is achieved by filing a certificate of incorporation. Delaware is strongly recommended due to its efficient process, speed, and prevalence among public companies, which can also be a requirement for certain investors. Online platforms designed for startups, such as Clerke and Stripe Atlas, are highly recommended for handling the incorporation process smoothly.
POST-INCORPORATION ESSENTIALS: FOUNDER STOCK AND VESTING
After incorporation, founders must formally issue stock to themselves. This involves a stock purchase agreement, often for a nominal fee combined with intellectual property contributions. Founder shares must be subject to vesting, typically over four years, meaning full ownership is earned over time. This protects the company if a founder leaves prematurely, as unvested shares are repurchased. A cap table, tracking all stock ownership, is essential and now easily managed with online platforms.
OPERATING AS A SEPARATE ENTITY: BANK ACCOUNTS AND TAXES
Treating the corporation as a distinct entity from its founders is critical. This includes opening a corporate bank account as early as possible, even with minimal funds, and using it for all company expenses. Founders should keep meticulous records and receipts if personal funds are used initially. Corporations must also adhere to tax obligations, including annual state taxes (like Delaware's) and filing federal tax returns with the IRS, even if no taxes are owed initially.
EMPLOYMENT, INTELLECTUAL PROPERTY, AND EMPLOYEE COMPENSATION
Founders and employees must be legally recognized as such. While early-stage startups may lack funds for salaries, founders should aim to pay themselves at least minimum wage if possible. Employment is typically 'at-will,' and formal employment agreements can complicate termination. Crucially, all individuals creating intellectual property for the company must sign Confidential Information and Invention Assignment (CI IA) or Proprietary Information and Invention Assignment (PI IA) agreements to ensure the company owns the IP.
COMMON STARTUP LEGAL MISTAKES AND PITFALLS TO AVOID
Several common errors can derail startups. These include delaying incorporation, which forfeits personal liability protection and the ability to easily raise capital; choosing an LLC over a C-corp when fundraising is planned, as most investors prefer C-corps; failing to read and understand all legal documents, especially founder stock agreements; and attempting to pay service providers solely with stock, unless they are properly classified as independent contractors. Founders should also be cautious about names that lead to trademark disputes or expensive domain acquisitions.
SPECIFIC LEGAL CONSIDERATIONS: 83(B) ELECTIONS AND IMMIGRATION
The 83(b) election is a crucial tax filing that allows founders to be taxed on the stock's value at the time of purchase rather than when it vests, which is usually advantageous given the low initial stock price. This election must be filed within 30 days of purchasing the stock. Immigration issues, such as obtaining visas like the TN visa for Canadians, are complex and best handled by immigration law experts, as YC partners are not specialists in this area.
CORPORATE STRUCTURES: C-CORP VS. S-CORP AND INTERNATIONAL OPERATIONS
For startups, a C-corporation is generally preferred, especially in Delaware, as it aligns with investor expectations and avoids issues with S-corp elections that typically terminate upon receiving outside investment. When expanding internationally, decisions about where to incorporate and establish subsidiaries should be driven by market presence and customer base, though incorporating in the US is often recommended for easier fundraising. Hiring employees in foreign countries requires navigating local labor laws and potentially establishing local entities.
EMPLOYEE STOCK AND ADVISORY ROLES
When hiring early employees, it's standard to set aside equity, typically 10-20%, for a stock option pool or grants under a stock incentive plan. While some online platforms can help set up option pools at formation, many companies adopt them later. Compensation for advisors is a sensitive topic; advisors should ideally invest rather than merely advise for free equity, though exceptions exist for specialized roles, especially in life sciences. A stock incentive plan is necessary for granting stock options, which may require a 409a valuation.
MANAGING FOUNDER RELATIONSHIPS AND INTELLECTUAL PROPERTY
Founder disputes are a significant cause of startup failure. It is vital to address disagreements proactively and resolve issues swiftly to avoid damaging the company and friendships. Key legal agreements, like vesting on founder stock and CI IA/PI IA, significantly reduce legal complications during co-founder breakups. Paying attention to document details, such as signed and dated versions, is essential during due diligence, especially when preparing to raise funds.
LEGAL DOCUMENTATION AND THE ROLE OF EXTERNAL COUNSEL
Maintaining organized and accurate legal documentation is paramount. This includes storing signed formation documents, stock agreements, and CI IAs securely, perhaps in a shared cloud folder. While online legal services are excellent for initial setup and standard processes, engaging traditional law firms becomes necessary for complex situations, significant fundraising rounds, custom agreements, and specialized legal advice, such as intellectual property protection or navigating regulations like GDPR.
Mentioned in This Episode
●Software & Apps
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Startup Legal Mechanics Checklist
Practical takeaways from this episode
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Common Questions
An 83-B election is a tax form that allows founders to elect to be taxed on the difference between their stock's purchase price and value on the day they buy it, rather than as their stock vests. This is usually beneficial for founders paying a nominal price for their shares, deferring taxes until the stock's value significantly increases.
Topics
Mentioned in this video
A legal expert discussing startup mechanics and legal aspects of forming a company.
A legal expert participating in the Q&A, discussing topics like equity for key hires, non-profits, advisory boards, and shareholder agreements.
A founder of Clerke, mentioned as participating in an AMA session, indicating expertise in startup legal platforms.
CEO of YC, who will be discussing product development and product-market fit.
Mentioned alongside Michael Seibel from Weebly, discussing product building and product-market fit.
A legal expert participating in the Q&A, discussing topics like 83-b elections, C-corps vs. S-corps, unpaid interns, partner invitations, legal tech, patents, firing co-founders, and privacy policies.
Founder of Y Combinator, mentioned as having a conversation scheduled for Friday.
An online platform recommended for incorporating startups, noted for its comprehensive services beyond just formation, including post-incorporation documents.
A platform that displays company funding rounds and financial details, often publicly available through charters and filings. The advice is not to worry about this early on.
A short and simple document filed with the Department of Corporations to form a separate legal entity for a startup.
A record of every share of stock issued by a company, crucial for tracking ownership and essential for fundraising. Online platforms are now available to manage these.
A legal warning issued by one company to another, often related to trademark infringement, which can be a significant distraction and expense for early-stage startups.
Documents that can be generic for startups and are part of the incorporation process.
An agreement that protects a company's confidential information and trade secrets, ensuring all intellectual property created is owned by the company. It's crucial for all founders and employees to sign.
A required component of a startup's incorporation process, often initially comprised of founders, and does not necessarily need to have an odd number of members.
The agreement founders use to purchase their shares from the company, often involving a small cash amount and contribution of intellectual property, with shares typically subject to vesting.
A standard corporate structure by default in Delaware, preferred by investors and typically used for startups seeking external funding, as opposed to an S-Corp which has pass-through taxation.
A plan to grant stock options to employees, which typically needs to be adopted later in the company's lifecycle and requires a 409a valuation, making it more complex than issuing restricted stock early on.
A valuation required when granting stock options to employees, often not performed by startups until after a fundraising event due to its complexity and cost.
The process of officially registering a company's name as a trademark, considered a 'nice to have' rather than a 'need to have' in the early stages of a startup.
Regulations governing the collection of personally identifiable information from individuals in the EU, creating a complex compliance landscape for companies, often requiring legal counsel.
A corporate structure with pass-through taxation, but it typically cannot accept investment from outside investors and may be dissolved by an S-Corp election.
A tax election that allows founders to pay taxes on the difference between the stock's value and purchase price on the day of purchase, rather than as stock vests. It must be filed within 30 days of buying the stock.
A corporate structure for social enterprises that balances profit with public good, changing fiduciary duties. While gaining popularity, it may be less attractive to traditional venture investors seeking high growth.
An online platform recommended for incorporating startups, praised for its ease of use, speed, and offering post-incorporation documents, unlike some less capable platforms.
A platform that displays company funding rounds and financial details, often publicly available through charters and filings. The advice is not to worry about this early on.
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