Key Moments
Legal and Accounting Basics for Startups with Kirsty Nathoo and Carolynn Levy (HtSaS 2014: 18)
Y CombinatorKey Moments
Startup legal and accounting basics: formation, equity, vesting, fundraising, and founder employment.
Key Insights
Founding a Delaware C-corp is the standard and investor-preferred structure for startups.
Equity allocation should be equal among founders to ensure alignment; execution matters more than the initial idea.
Vesting schedules, typically four years with a one-year cliff, are crucial for aligning founder incentives and protecting the company.
Startup fundraising often uses convertible notes or SAFEs for unpriced rounds, with valuation caps to reward early investors.
Founders and employees must be paid salaries and have IP assigned to the company. Using a payroll service is essential.
Properly document everything, keep records organized, and use standard legal documents to avoid future complications and costs.
FORMING YOUR STARTUP: THE DELAWARE ADVANTAGE
Establishing a separate legal entity is paramount for protecting founders from personal liability. While theoretically many jurisdictions exist, Delaware is the standard and preferred choice due to its well-settled corporate law, familiarity for investors, and streamlined processes. Forming as a Delaware C-corporation simplifies due diligence for investors and avoids costly reincorporation later. Even simple formation errors, like remaining an LLC, can lead to significant financial and legal complications, underscoring the importance of choosing the right structure from the outset.
STRUCTURING EQUITY: FAIRNESS AND ALIGNMENT
For startups with multiple founders, equitable distribution of equity is critical for long-term alignment and preventing future disputes. Execution, not the initial idea, creates value, so avoid disproportionately awarding equity based solely on who had the idea. Equal or nearly equal splits signal founder unity and shared commitment. Disparities can indicate a lack of trust or misaligned expectations. Founders must focus on the long haul: past contributions are less important than future commitment. Top-performing Y Combinator companies rarely have significantly unequal founder equity splits.
THE MECHANICS OF STOCK OWNERSHIP AND VESTING
Owning stock requires formalizing agreements through a stock purchase agreement, where founders essentially buy shares from the company, often in exchange for cash or intellectual property. Restricted stock, subject to vesting, means full ownership is earned over time. A standard vesting schedule involves a four-year term with a one-year cliff, meaning 25% of shares vest after the first year, and the remainder monthly thereafter. Vesting protects the company by allowing it to repurchase unvested shares if a founder leaves, thus incentivizing commitment and preventing founders from leaving early with a significant equity stake.
NAVIGATING FUNDRAISING AND INVESTOR TERMS
When raising capital, startups typically use unpriced rounds via convertible notes or SAFEs, where the investor's valuation is set at a future priced round, often with a valuation cap to reward early risk. Priced rounds, like Series A, involve setting a specific valuation. It's crucial to understand dilution—how each funding round reduces existing ownership percentages. Investors will also negotiate terms like board seats (generally best avoided unless offering significant strategic value), advisor roles (often redundant if investors are engaged), pro-rata rights (the right to maintain ownership percentage), and information rights (requiring regular updates, but beware of overreach).
FINANCIAL MANAGEMENT AND BUSINESS EXPENSES
After securing funding, meticulous management of business expenses is vital. All company expenditures must be paid from the company's bank account and clearly categorized as legitimate business expenses to be tax-deductible. Founders must distinguish personal spending from company spending, as investor funds are for business growth, not personal use. Maintaining organized records and receipts is essential for bookkeepers and CPAs to accurately prepare tax returns. Misappropriating funds is essentially stealing and can have severe consequences for founders.
FOUNDER AND EMPLOYEE COMPENSATION AND IP ASSIGNMENT
Both founders and employees must be paid a salary, with minimum wage being the legal floor; working for free endangers the company. Utilizing a payroll service is highly recommended to manage payroll taxes and compliance, preventing legal disasters. Furthermore, all individuals, including founders and employees, must formally assign any intellectual property (IP) created for the company to the company itself. This IP assignment is fundamental to the company's value. Understanding the distinction between employees and contractors is also crucial, as each classification has different legal and tax implications.
HIRING, FIRING, AND PROFESSIONAL CONDUCT
When hiring employees, ensure proper classification (employee vs. contractor), verify their authorization to work in the U.S., and obtain a workers' compensation insurance policy. Firing an employee, though difficult, is a necessary part of running a company professionally. It should be done quickly, clearly, and respectfully, with all final wages paid immediately and access to company systems revoked. A founder's ability to handle terminations effectively is a hallmark of strong leadership, prioritizing the company's well-being over personal ease.
THE IMPORTANCE OF ORGANIZATION AND COMPLIANCE
Throughout a startup's lifecycle, maintaining organization and adhering to legal and financial rules are non-negotiable. This includes keeping critical documents safe and accessible, using standard legal templates where appropriate to reduce costs, and understanding key metrics like cash position and burn rate. While not the most glamorous aspect of entrepreneurship, seriousness in compliance, proper paperwork, and understanding financial basics will prevent significant pain and costly mistakes down the line, allowing founders to focus on building a successful business.
Mentioned in This Episode
●Software & Apps
●Companies
●Organizations
●Concepts
●People Referenced
Startup Legal and Accounting Checklist
Practical takeaways from this episode
Do This
Avoid This
Common Questions
Delaware is highly recommended for incorporating startups due to its clear and settled corporate laws, and its familiarity and comfort for investors, simplifying the fundraising process.
Topics
Mentioned in this video
Mentioned in an example of an employee retaining access to company systems after termination.
The organization hosting the lecture, frequently cited for its practices and recommendations for startups.
An online service recommended for helping startups with incorporation and standard legal documents.
Used as an example to illustrate the distinction between personal and company expenses.
Warned against as a startup formation choice, suggesting Delaware corporation as a better alternative.
Mentioned as an example of a regulatory complexity that might necessitate legal counsel for a startup.
Used as an example of incorrect startup formation that led to significant legal costs.
A common instrument for unpriced fundraising rounds, allowing future stock conversion at a set price or discount.
Simple Agreements for Future Equity, a common instrument for unpriced fundraising rounds.
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