Startup Tax Filings: Get Them Done Efficiently

Background Reading: 7 Biggest Tax Mistakes New Startups Make

A recurring theme on this blog is that, at the very early stages of a startup, running “lean” should not mean finding garbage service providers who’s shoddy work will end up costing 5-10x to fix later on. It does mean being smart about whom you hire and ensuring you get cost-effective, quality work that’s appropriate for the task.

Previous examples:

  • Clerky for the 1-2 founders who just need to incorporate, assign some IP, and issues stock with vesting schedules, but not necessarily engage lawyers yet.
  • SnapTerms for the SaaS startup that just needs a decent TOS/Privacy Policy to get up and running.
  • eShares for the startup that needs to track capitalization, issue certificates, or get a 409A valuation.

And at this time of year, it’s only appropriate to bring up another thing that early-stage startups need to get done, but often screw up by going cheap instead of going efficient: taxes.  Trust me, at some point your taxes will be diligenced by investors. You don’t want this holding up your Series A closing.

Thankfully, I’ve found a startup that helps other startups get this done easily and efficiently: LiveWire. $399+ to have a professional handle your startup’s taxes, paperlessly via the web, so you can get back to work. A whole lot easier and cheaper than engaging a CPA old-school or tinkering with an inflexible piece of software.  And lest you question the user experience, check out the reviews.  If you’re an early-stage founder who hasn’t the slightest clue how to file taxes for your startup, but realize you’re too early for fully engaging an accountant, this is the place to go.

As always, I don’t hold a financial interest in any of the companies referenced above. 

The Texas Startup Ecosystem: Curated & Connected

Nutshell: You can’t build a startup alone. Find your city’s startup “watering hole,” and start drinking.  But remember: that watering hole is not a charity.

In a world of abundance, including abundance of noise, curation becomes incredibly valuable.  Few people have the time to sort through hundreds of duds (products, information, people) before finding something or someone that they truly need. Curation is actually one of the main points of this blog; particularly the Learn the Essentials section. Undercapitalized Texas founders need information on basic startup law and finance.  That information has historically either been locked up in expensive silos (law firms), or spread out over the web alongside loads of crap.  I help them avoid the noise.

If you (just) build it, they won’t come.

When I run into very green founders, my first piece of advice is always simple and direct: get plugged in. By that I mean find people who “do” startups: either as  founders, developers, investors, advisors, etc. – and start making connections. It’s great to rely on your friends and business associates for general advice, but unless they work specifically in startups, it will not be good enough.  The challenges you encounter as a founder of a tech startup (business, legal, financial, etc.) will be very different from those that people outside of that space have experienced.  You need specialized advice, and that means specialized people.

And founders absolutely need to dispel any “if you build it, they will come” (just focus on the product) thinking. No, they won’t come. You probably don’t know how to build it in the first place. And even if you do, distribution matters.  You or someone working for your startup needs to be out there building relationships. Every startup needs at least one hustler. 

The Noise

Naturally, the number of these specialized “startup people” is a tiny fraction of the general business community in any particular city; especially in large cities with relatively small (but growing) startup communities.  But as startups have become much more of a “hot” topic (evidenced by political campaigns and a boom in angel investing among non-tech people), everyone and their mother has suddenly decided to bill themselves as a startup consultant, mentor, advisor, founder, whatever.  You see this in the legal field, where lots of general business lawyers have suddenly become ‘startup lawyers’ overnight. There are also a lot of business executives trying to mentor startups, with zero experience having actually worked with one.

So knowing that they need to find good startup advice, but there are a lot of duds out there, what are founders to do?

People, Curated

As the Texas startup ecosystem continues to mature, in each major city we’re seeing startup “hubs” emerge: places where the signal-to-noise ratio of real, valuable startup experience v. ‘everything else’ is orders of magnitude better than throughout the rest of the city. They’re like watering holes for the founderati. Startup people, curated for you. You’ll find far more jeans and sneakers than slacks and loafers in these places.  That’s a very good thing.

To help Texas founders get plugged in , I’ve created lists for Austin, Houston, and San Antonio (cities where the majority of our client base is) of the key startup locations, events, and even people in each city.  While every incubator, meetup, and person that I list on those pages is a great resource, there are stand-out “core” places that, in my opinion, any new founder should use as a starting point for plugging in – by following their posts, attending events, etc.

In Austin, Capital Factory has by far emerged as the largest “hub” of the startup community. Tech Ranch, while somewhat less well known, is also an important player. While not physical spaces, Austin Open Coffee and Austin Lean Startup Circle are also regular meetups whose attendees pack a significant amount of startup experience.

In San Antonio, Geekdom is hands-down the epicenter of the startup community. I’ve yet to encounter a serious startup out of San Antonio that has not connected with Geekdom in some way.  SA New Tech, a regular meetup, also has a solid attendance.

In Houston, the Houston Technology Center (HTC) appears to be evolving into a core of Houston’s startup community. Not exactly a cultural/social hub (yet) the way CF is for Austin or Geekdom is for SA, but an important player. The Houston Lean Startup Circle  is also very well attended by experienced startup folks.

Dallas is noticeably absent from this list. I frankly don’t work a lot with Dallas startups, and I only write about what I know. Also, there are a lot of very important players in these cities that I didn’t mention (accelerators, investors, etc.) simply because the point of this list is to emphasize how very early-stage founders should get ‘plugged in’ to their startup ecosystem. A brand new founder shouldn’t be “plugging in” to accelerators or investors.

Eyes Wide Open

Texas founders benefit enormously from the above institutions.  The connectedness and collaboration that result from their “dense” environments of startup activity are absolutely essential to a thriving Texas startup ecosystem.  All that being side, founders need to understand that these are not charities, and the people running these organizations (while great) are not Mother Teresa.

A number of the “startup hubs” in any city are either for-profit themselves, or connected to/run by very for-profit investors. The density that they provide is not strictly for the public good: it’s a way to pool resources and systematically reduce the search costs for (i) investors looking to invest in great startups, and (ii) executives looking to join startups on the rise.

There’s certainly nothing wrong with this. Doing well by doing good is awesome. I “do well” by this blog just the same. But founders should avoid becoming naively enamored and approach these institutions for what they are: very useful players in a profitable market for influence.  That market is competitive (incubators, accelerators, co-working spaces, etc. are in competition), and the players are incentivized to do and say things that maintain their influence, but aren’t always in the best interest of founders.  Founders should absolutely plug themselves in, but keep their eyes wide open in doing so.

 

409A as a Service: Cash Cows Get Slaughtered

Background: 409A is a set of tax rules passed, in part, to stop companies from avoiding taxes through issuing underpriced (cheap) equity as compensation.  While well-intentioned, it spawned a cottage industry of third-party valuation firms/i-bankers who charge companies, including startups, thousands (sometimes tens-of-thousands) of dollars to get ’409A valuations’ for their stock to avoid tax penalties in setting their stock’s Fair Market Value.

Anyone who deals with 409A valuations on a regular basis knows that they are the quintessential ‘cash cow’ for valuation firms and small i-bankers; evidenced by the number of those firms that are constantly inviting lawyers and influential tech players out to lunch in order to get referrals (btw, sorry guys, I’m blogging right now). And if they’ve dug a little deeper, they’ve found that, particularly at the early stage, these valuations are generated in an almost entirely automated fashion. Hence, cash cows: premium price, lots of hand-waiving to make them seem difficult to produce, but ultimately with a low marginal cost.

The Necessary Evil

In practice, startups have been advised by lawyers and their advisors to avoid a 409A valuation until a Series A. Pre-Series A there’s usually not much on the balance sheet and no arms-length price on the Company’s equity to generate a meaningful valuation, so startups just wing it.  Post Series A, however, the vast majority of startups pony up $3-10k to get their valuation, and it has to be refreshed (i) every 12 months, (ii) if there’s a material change in the startup’s financials, or (iii) if a new equity round is done; otherwise it goes ‘stale’ and no longer provides a safe harbor on FMV.

That can get expensive quickly, though any serious company looking to get acquired by a large company or eventually go public knows that the consequences of not doing this can be substantially more expensive.

409A-as-a-Service: The Slaughtering

Finally, eShares (the paperless stock certificate and capitalization tracking company) has pulled off something brilliant: 409A as a Service. Priced as a continuous service (which makes total sense given the on-going need for re-doing a valuation) and supported by a well-known valuation firm (Preferred Return) startups get continuous 409A valuation services at a monthly fee: $159/mo for a post-Series A startup – higher for later stage.

Doing the math, that’s $1,908/yr: easily a 40-50% discount on even the most ‘sweetheart’ deals offered by local valuation firms for post-Series A startups. If you need a refresh within a year, you’re in 90%+ discount territory. Add in the fact that (i) it’s done paperlessly via the web, and (ii) the valuation gets continuously updated for major changes in capitalization or financials (no huge cost to avoid going stale), and we have ourselves a game-changer.

The pricing for Series B, Series C+ valuations is even more competitive relative to market rates for 409A services.  It’s also a brilliant feature for eShares because of how it ties in directly with their existing capitalization tracking platform.

Something tells me that this slaughtered cash cow is going to net eShares and Preferred Return a lot of steak dinners in the future.  The cottage i-bankers who’ve built practices off of milking 409A as much as possible? Not so much. The better i-bankers of course do higher-value things that justify their costs, so they have nothing to worry about. Yes, there are serious parallels to startup law here.

Nutshell:  Startups historically had to pay $3-10k for a valuation after closing a Series A in order to protect themselves from 409A issues, and they had to keep re-paying it on an on-going basis to keep it from going stale.  eShares has changed all of that by offering 409A valuations as a continuous service (as they should be) and pricing them in a manner that aligns more closely with what it costs to produce them.  Cash cows, particularly when visible to techies who like to disrupt things, eventually get slaughtered.

p.s. Like all of the other tools I recommend to startups for saving their capital, I have no financial interest in eShares.

What a Valuation Cap Isn’t

Background Reading

The always awesome Joe Wallin, together with Adam Lieb, recently wrote a post (link above) outlining how valuation caps on convertible notes work.  Founders should read it. In a nutshell, a “cap” is a limit on the valuation that a convertible note will convert at upon a “qualified financing.” Seems simple enough, but there are a few serious misconceptions about valuation caps that I feel someone should clear the air on.  Here’s what a valuation cap isn’t. 

1.  A Valuation Cap is Not a Valuation

Sort of.  In the strictest technical sense, a valuation cap is not a valuation.  It relates to future valuations.  It also doesn’t (generally) require a re-valuation of the FMV of your company’s equity for stock grant purposes.  And if a Series A ends up happening at a valuation below the cap, it’s not exactly considered a “down round.”

But in practice, investors and founders often treat caps like valuations.  When you come across an AngelList profile saying a startup is raising $500K at a $4M ‘valuation’, the majority of the time they mean they are issuing convertible notes with a $4M cap.  This “sort of but not really a valuation” aspect of capped notes is seen by some as the best of both worlds: you get to price a round without all the costs of negotiating  a full set of equity docs.  Others see it as having removed the main benefit of issuing notes (instead of equity) in the first place: deferring a valuation discussion to a future date.  Both sides have good points.

2. A Valuation Cap does not guarantee investors a minimum % of the Company

This is the issue that really needs the most clearing up.  I’ve seen angels make the claim that a valuation cap guarantees an angel a specific % of the Company post-Series A. This is just not true.  In a theoretical sense, a valuation cap guarantees a minimum pre-Series A % of the Company, but the note-holder never actually owns that % because the Series A money comes in alongside the conversion.

Take the example in Joe’s post:

  • $5M cap, $200K in notes (assume no interest for simplicity), $2M in new money at Series A at a $10M pre-money valuation.

I’ve seen investors do the following math:

  • % Ownership Post-A = Investment / (Cap + Investment)
  • So: $200K / ($5M + $200K) = ~3.8%
  • Therefore, they say, the note-holder should own 3.8% of the Company after the Series A.

The problem, of course, is that the new $2M from the Series A is nowhere in this equation.  That 3.8% is a percentage of the Company without the new Series A money coming in.

When you do the math correctly for the full Series A (see Joe’s post), the noteholder’s % comes out to 3.22% of the Post-A company. That’s the number the investor(s) will see on the cap table after conversion. And it could be higher or lower depending on the economics of the Series A.

This kind of confusion shouldn’t happen if you’re working with seasoned angels who’ve done several investments that have gone on to raise a Series A.  But if you’re not (often the case in Texas), make sure they understand the math of their own investment so there aren’t squeals when conversion time comes around.

Don’t Ask Your Startup Lawyer for Investor Intros

Principle:  Nothing says “I can’t hustle” like a paid introduction.

A lot of young founders looking to raise seed funding for their startup go through the following thought process:

  • I need to get in touch with investors, but I don’t know any of them.
  • Well-known Startup Lawyers must know investors, and I need one anyway;
  • Therefore, I should ask the Startup Lawyer that I hire to make some investor intros for me.

The logic here isn’t bad. In fact, some startup lawyers emphasize their strong relationships with investors as a marketing pitch to companies.  Unfortunately, those relationships are sometimes too strong.

Yes, good startup lawyers do know many investors, and yes, they certainly can make investor intros.  The truth is, though, you shouldn’t want them to. Before I explain why, a bit of background facts:

  • Startup investors, particularly VCs, receive hundreds, maybe thousands of pitches every year.
  • There are very few areas of investing that carry as much uncertainty/risk as startup investing.
  • Therefore, investors rely on as many signals (shortcuts) as possible for filtering out founders that can’t build a successful business.
  • The ability to hustle (related to and including networking) is extremely important for a startup team, or at least the founder who will play the CEO/business role of the startup (investors will excuse a technical co-founder who sits in a closet all day coding); and
  • Finally, VCs often intentionally make themselves difficult to get ahold of as a way to test (find a signal for) the networking skills of founders.

As a sidenote: cold calling/e-mailing VCs almost never works, for the above reasons.

Hustle Deficiency

So here’s the big issue: if you type a well-known investor’s name into LinkedIn, there’s a 99% chance that you’ll find 100s of different “paths” to get an introduction to that investor. Twitter also often helps.  Now, of all those paths to an intro, what do you think it signals to the investor if the only person you could find to introduce you is someone you’re paying?  The first thing that will run through that VCs mind will be something like “huh, well, putting aside the actual business idea, the founder clearly sucks at networking.”  That’s not a first impression you want to make.

A second thought might be, “maybe they’re not bad at networking, but just couldn’t find someone to sincerely recommend them.” You get the idea. Having your lawyer introduce you to investors isn’t too far off from having your mom write you a reference for a job.

What good is my Startup Lawyer then for helping get investment?

Does this mean whom you hire as your Startup Lawyer is irrelevant as far as finding investors is concerned? No, it still matters, just in different ways.  A knowledgeable startup lawyer can help with (i) how to approach particular investors, (ii) making recommendations as to which investors would be better targets, and (iii) signaling to investors that there’s been some “adult supervision” in the Company’s development to avoid legal land mines.

Because reputable startup lawyers are (often) selective as to whom they represent, a good startup lawyer can also signal that, by representing you, he/she at least thinks your startup has good prospects.  Granted, a lawyer’s business judgment isn’t exactly on par with Warren Buffet’s or Paul Graham’s (obviously, he wouldn’t be lawyering if it was), but it’s something.

Nutshell:  Ask your Startup Lawyer for suggestions on whom you should seek intros to, and on how to do it, but don’t ask him for the intro itself.  It’ll just make an investor think that, because you resorted to a paid intro, the company lacks a competent hustler. Nobody wants to invest in a hustle-deficient startup.