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 whose 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. 

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.

The Deflation of Startup Law Continues: Clerky

Almost exactly a year go, I wrote a post (The Economic Deflation of Startup Law) in which I (i) documented how the rapid adoption of technology and standardized contract language in early-stage startup law was dramatically deflating the cost of quality (crappy law has always been affordable) legal services available for founders, and (ii) made a few predictions about how this might affect the segment of the legal market that serves early-stage tech entrepreneurs.

Background

  • Contractual Changes – Standardization of contract language within law firms  & the emergence of universally standardized documents like the NVCA model docs, Series AA, and Techstars Docs, to name a few.
  • Technological Changes – Proofing software, Document Automation, Electronic Closing, etc. – reducing the amount of lawyer time required to complete a formation, bridge financing, etc.
  • Operational Changes – Technology and standardization simplify the labor input required to complete a transaction, allowing less trained, less expensive professionals to perform more of the back-end work.
  • Deal Platforms – Technology is moving from being merely a tool within the traditional law firm process to a bilateral platform that allows parties on both sides of a transaction to close, from beginning to end, with significantly less lawyer time required.
  • Freemium Startup Law – Very early-stage legal work (formations, bridge/seed financings, routine forms), once the bread-and-butter of solo lawyers and boutiques serving entrepreneurs, will no longer support those practices, no matter how efficient they try to be.  The margins will be too thin.  Those attorneys able to serve higher-quality, later-stage clients (those that make it to Series B, C, exit) where legal work will remain much more high-touch, high-margin will dominate the market and cross-subsidize their work for premium early-stage clients.  In short, Startup Law will move closer to a freemium model, where standard work is free (or almost-free) and being able to attract “premium” clients is essential for profitability.

The point of this post is not to comment on the accuracy of my predictions. One year is too short a time-frame to judge (we’ll see in 3-4 more years), though I will say that in Austin’s legal market I’ve seen a definite trend of solo and almost-solo lawyers attempting to expand their practices into multi-specialty firms, suggesting their desire (or need) to move up-market. Nationwide, I’ve also encountered a few small firms with much higher-caliber partners/associates, broad networks of specialists, and low-overhead platforms to compete head-on with BigLaw: this is where things will get very interesting.

Deflation 2.0 – Clerky

Instead, I’d like to talk about how the above developments have manifested themselves in the form of a Y-Combinator startup called Clerky. Details:

  • Founders are UPenn and Harvard (represent!) JDs of Orrick pedigree, and the head partner of Orrick’s Emerging Companies Group is an advisor; lest you question the quality of the drafting.
  • Appears to have handled formations for several Y-Combinator classes (note: classes - hundreds of companies) over the past several years; lest you think they haven’t been vetted and won’t get traction.
  • For formations, founders fill out online questionnaires very similar to those used by startup-focused law firms, and documents are automatically populated with the appropriate names, numbers, vesting schedules, etc.
  • There is a “reviewer” option where the founders can designate a person (an attorney) to review the final documents pre-execution to give a thumbs-up.
  • Execution is handled electronically on the platform.
  • Delaware filings and registered agent registrations are handled by Clerky.
  • Final executed documents are stored online.
  • Currently Available: Simple Incorporation (no equity, IP docs, etc.) – $99. Full formation (equity docs with vesting, IP assignment, bylaws, etc. – option plans and indemnification agreements coming soon) – $398.
  • Coming Soon (In Private Beta): Employee Offer Letters, Consulting Agreements, Advisor Agreements, NDAs, Convertible Notes., LLC to C-Corp Conversion

So what exactly has Clerky done? Once they get option plans and indemnification agreements up and running, they will have taken what would cost $5K-10K in legal fees at an inefficient law firm (or $2.5K-$5K at a more efficient one) and reduced it to $398 by going one step past building tools for lawyers to developing a platform that effectively replaces them – or at least ~95% of the work they do for early-stage clients. LegalZoom prices, but for premium, startup-focused documents.

What about free options?

Major law firms have attempted to address the large portion of the founder population for which even $2.5K-$5K is too high a formation price tag by offering documents online for free. I even wrote this post offering my own checklist for forming your own startup and issuing equity, lawyer-free, via publicly available documents.  But $398 is close enough to free that founders in this same category will be willing to pay for peace-of-mind, knowing that their docs are filled-out and filed properly, and that a reputable service is helping them maintain them. Plus it’ll save them hours of having to read the forms themselves.

Curmudgeon Criticism 1: Founders will want more customization than Clerky Offers

Yes, there will always be a segment of the founder population that wants high-touch, custom lawyering from the very beginning and will pay for it; just as there are people for whom Nordstrom or Macy’s isn’t good enough for their clothing and require tailors and boutiques.  But the reality is that for the large swath of the pre-funding founder population (95%+) that just wants to “get the job done” and focus on their product, Clerky, with its 80-90% discount on even the most efficient startup lawyers, will be a viable option. Those lawyers who’ve offered quality startup formations for $2.5K have themselves done so by limiting the amount of customizability and focusing on standard terms, so the difference in terms of documents between what you would get from a lawyer v. from Clerky will be very small.

Curmudgeon Criticism 2 Good lawyers will never accept a third-party service’s drafting language for their own clients.

After an inevitable phase of whining, kicking, and screaming, smart lawyers will accept whatever good clients and the market dictate, or they’ll just leave the space.  As stated above, there will always be clients who are willing to pay a premium for ensuring that all of their lawyering is 100% airtight, but those clients will be fewer and farther between.  And you can certainly expect a chorus of lawyers poking through the Clerky docs with a laundry list of ways their own documents are better. But like many disruptive innovations, it’s about the ratio of quality to cost, not absolute quality. At $398 for documents based on those used by one of the country’s leading tech firms and delivered by a YC company run by Ivy-League JDs, the value for founders is unquestionable. Quality, both in terms of legal drafting and user experience, will also improve over time.

Clerky will allow founders to engage quality, scalable lawyers earlier on.

Clerky’s “reviewer” option and its clear intent to incorporate lawyers in their processes shows that the goal here is not to completely replace lawyers, which would clearly be silly and reckless. The nuances of individual circumstances, the need for sound professional judgment that can’t be reduced to an algorithm, and the general realities of running a company will always require good, human legal counsel.

What a service like Clerky does is allow founders with very low legal budgets to stop having to settle for low-quality, mismatched lawyers who end up costing a whole lot more money (in mistakes) than founders expect. As I wrote in a previous post, a lot of founders know they need a lawyer, but can’t afford a good one, so they take the “staging” approach of going cheap up-front with plans to “upgrade” later. The consequences of this approach can be very expensive, and often disastrous.  Founders need lawyers that can serve them at all stages of development, not just when they’re tiny and the stakes seem low.

With Clerky, the “cost” of hiring a good lawyer at the very early stages of a startup can be the time it takes to quickly review some Clerky docs and answer any questions a founder might have about non-standard matters. For quality startup lawyers who stop pretending that all document drafting, no matter how routine, needs to occur in private silos, this is liberating. They can focus their practices on more complex matters that are far more profitable and interesting from a professional standpoint, while still maintaining relationships with early-stage clients who might one day require their skills. It also means the need for deferring fees will be dramatically reduced.

A missing piece: what do the documents say?

One issue that has gone under-addressed in the startup legal landscape is how to make all these automated legal documents understandable to founders.  While no founder should care to understand all the nuances of their option plan, stock purchase agreements, etc., they should at last be able to grasp at a high-level the concepts that they contain.  And sitting down with a lawyer for every explanation is and always will be too expensive for most founders.

Offering lists of books and links to founders is very helpful.  A “customer support” model of cheaper professionals without JDs who can easily answer common founder questions will also likely emerge.

One startup here in Austin is taking an interesting approach: crowdsourced annotations of contracts (Lawful.ly). They call themselves the “Rapgenius for Law.” Imagine having all of the legal forms that your startup uses available online with annotations, so you can click around the document and get plain-english explanations of what a particular provision means. That’s what they are working on, and hopefully it (or something similar) will fill a gaping hole in the early-stage startup law landscape.

For lawyers who’ve built their practices on charging clients thousands of dollars for basically filling in forms and doing some cutting-and-pasting, the future looks increasingly grim. For those of us who love working with entrepreneurs and tech companies, but find cookie-cutter legal work utterly boring and a waste of our intellect, life is getting a whole lot better.

Integrated Startup Law — Specialists Matter

Without getting bogged down on details, you can largely categorize physicians as general practitioners and specialists. Generalists are the every-day doctors that provide primary care for more routine matters, and also (hopefully) coordinate care with specialists (cardiologists, neurologists, etc.) when appropriate. Unfortunately, the U.S. healthcare system does a terrible job on that second part, but this is a blog about startup law, not healthcare. End of digression.

The practice of transactional law, including startup law, can also be categorized in this way.  A “corporate lawyer” serves the role of the general practitioner. Her job is to handle the more common matters that a client is likely to encounter, and to coordinate with specialists (tax, labor, IP, etc.) when their input is needed.

Biology is Integrated

Anyone who’s studied health policy knows that, by far, the most effective and efficient healthcare delivery models in our country — Kaiser Permanente, Mayo Clinic, etc. — are what many call “integrated.” Specialists and generalists work under the same system, and share information with one another in as frictionless of a manner as possible. The reason for this is that the human body itself is an integrated system. The heart doesn’t operate in complete isolation from the brain any more than my macbook’s hard drive operates in complete isolation from the CPU.  So it makes little sense that medical practitioners who specialize in different systems of the body work alone, as if the knowledge of other specialists is irrelevant to their own work.

Startup Law is Integrated

What I try to ensure that our clients appreciate is that the law itself, including the law that affects startups on a daily basis, is also integrated.  Even at the most standardized of startup legal events — formation — there are at least half a dozen specialties of law that play a role in the steps a client needs to take.  Securities Law, Labor Law, Intellectual Property Law, Commercial Litigation, State Corporate Governance Law, Tax Law, etc.

A view commonly heard about early-stage startup law is that it’s all become so “standardized” that large, sophisticated institutions with specialists (not just generalists) are no longer needed to properly serve clients; the end-result being a retreat to a “cottage industry” mentality where small practices of generalists have set up shops pitching themselves as delivering the same service, but without all that unnecessary “overhead.”  Some have gone so far as to call this trend a “disruption” of law practice.

My response to this perspective is three-fold:

1. “Standardized” and “Simple” are not the same thing. Not even close.

Production of the iPhone is standardized; otherwise no one would be able to afford it. But that doesn’t mean the design and building of the iPhone is “simple” in a sense that it could be produced by a fragmented cottage industry lacking the resources of Apple.  In the same sense, the set of twenty or so documents that we produce for our startup formations has become standardized to the point that we can produce it quickly at scale, but the expertise of at least half a dozen specialties went in to producing it, and is required to constantly update it and ensure it fits the current state of the law.  A set of lone generalists, even brilliant ones, simply wouldn’t cut it.

2. The exact same process, delivered from a smaller office, while wearing denim, does not a disrupter make.

Disruption of an established industry comes from delivering what consumers want, but in a radically different, often cheaper way.  Productizing the expertise of highly educated and specialized individuals and delivering it at scale so that far more people can afford it: that is disruptive – and it’s happening in startup law.  Cutting off the relevant expertise of a large portion of the profession, moving into a smaller office space, and continuing to deliver the product in the exact same way: t’is not disruptive.

Because smaller legal practices often do have salary structures that lower their labor costs, they do tend to have lower hourly rates.  But many (that I’ve encountered) use this lower labor cost as an excuse to avoid adopting the kinds of technology and practices that actually make the delivery of startup law efficient.  In other words, “our hourly rates are lower, so it’s OK if we take longer to do something.”  People operating in Big StartupLaw, particularly techies like myself, are often floored to see how backward some (not all) smaller practices are. This is not a space for “cottage” practitioners, though not all smaller practices fit that definition.

3. Specialists will need to be consulted.

Forming your startup or raising a simple seed financing might be thought of as the legal equivalent of getting a cold (simple service is fine), but actions taken at the not-that-much-later stages of the startup, like drafting executive employment agreements, developing and protecting intellectual property, issuing securities, negotiating commercial contracts to be enforced in multiple jurisdictions; these can touch on legal nuances that are a whole lot more like brain or heart surgery. Leaving everything in the hands of a generalist can end up ugly.  We’ve seen this happen many times.

The high growth nature of tech startups means they can go from playing legal tee-ball to the major leagues very quickly, unlike most kinds of businesses that utilize small firms.  Legal representation that can scale with the startup at all of its stages, rather than max out once the startup becomes successful, is extremely valuable; particularly because the costs of switching law firms are not insignificant. The key is to find a firm that packages and prices its services appropriately for each stage of a startup.

Fragmentation v. Integration

Many smaller practices are well aware of these limitations in their model and have developed informal networks of specialists from other firms to call upon in situations when their expertise is needed.  I’ve touched on this topic here.  While this is definitely a good thing, thus far I’ve been unimpressed with the mechanisms (i.e. none) that smaller practices have put in place for actually drawing upon their “network” in an effective and efficient manner.

Having to formally engage a new law firm (including running a conflicts-check) to ask a question that someone under an integrated system could get answered by walking down the hall doesn’t exactly smell like progress to me.  Even if it works for lengthy, project-based engagements, the kind of quick, 15-minute consults that are commonplace (and necessary) in an integrated firm will inevitably go under-utilized in a system with that much friction.

Some “multi-specialty” firms have done a little better and brought in-house the handful of types of specialists that are most likely to be needed by a startup: employment, tax, and IP seeming to be the most common.  But that’s a tough model to sustain because those specialists almost invariably need to also work for large non-startup clients (the kinds that don’t work with small firms) to keep their practice profitable.

Of course, as in other industries, at some point the right platform for allowing a fragmented system of specialists to coordinate ad-hoc may emerge in a way that can match the quality and breadth of the integrated system. But for now, this “PC” of startup law is nowhere to be found.  For matters beyond the absolute most basic, Apple-like integration wins.  Note, however, that a smaller footprint can actually be the optimal model for attorneys/firms with enough brand recognition (gravity) to dominate a particular niche specialty (not generalist) of the market.

Conclusion: Process efficiency and technology innovation will disrupt legal practice. A “cottage mentality” will not.

Progress and innovation in the startup law space will not come from doing things the same old way, while wearing jeans in a less fancy office space.  It will come from sophisticated parties that, instead of retreating from the web of specialties that make up the field, find smart ways to affordably package and productize their knowledge.  This process is well underway, and it’s incredibly exciting to operate in.

DIY Startup Legal Tools: Self-Diagnosis v. Self-Treatment

Image by Barbara Krawcowicz via Flickr

I have an awesome idea for a startup. Let’s call it LunaDoc. LunaDoc will be a website where you answer a series of algorithm-based questions about a health-related issue you’re dealing with, and then it will suggest to you a diagnosis. Sounds great, right? That’s probably why dozens of these exist already.

But let’s go one step further. After diagnosing you, LunaDoc will generate a prescription and send it to your pharmacy of choice, after which you can pick it up without the hassle or expense of ever having to talk with an actual physician.

If you’re half sane, you should have suddenly thought something along the lines of, “Whoa there, tiger.” Why is that? Because self-diagnosis, or educating someone enough to better understand their problem, is great. But self-treatment, or turning that new knowledge into a high-stakes action with potentially permanent consequences, without consulting a professional, can be absolutely nuts.

Sidenote: As I’ve done many times before, I’m going to leverage this healthcare example into a metaphor for the startup law context.  I truly believe there’s a lot that people in startup law can learn from the healthcare profession, so I’m going to milk this metaphor until the cows come home.

Self-Diagnosis

For years entrepreneurs have been fortunate enough to have an incredible amount of accurate, well-articulated, and free knowledge about startup law issues on the web; some in the form of blog posts and some in the form of articles. I’m a huge fan of recommending online resources to clients as a way to educate themselves without being billed hundreds of dollars an hour for it. And it makes the time that I personally spend with them more efficient (and cost-effective) because we can get right down to business without having to go through basic stuff. I keep my stash of helpful online reading here: SHL – Startup Law Links. 

Startup law blogs and articles are the legal equivalent of healthcare websites that help with self-diagnosis. Their role is simply educational, and can help a client (patient) better engage a professional in turning the diagnosis into a solution. While some doctors might complain about patients becoming “google doctors,” a more educated client base is uncontroversially a net positive.

Self-Treatment: Guided v. Unguided

Lately, however, we’re starting to see the web do what it always does: provide tools that attempt to dis-intermediate an economic relationship and let people completely handle things themselves. Self-diagnosis is evolving into self-treatment.

Major law firms have started posting standardized contracts on their websites for free.  Capography, a really cool new tool, lets entrepreneurs manage their own cap tables and even run a limited number of waterfall analyses to see how funds would flow in an exit. Docracy has emerged as an incredible source for hundreds of free contract forms for a wide variety of contexts, and they even let you execute the contract from the comfort of your own home, without ever having to go through the hassle or expense of talking with an actual lawyer (sound familiar)?

The much greater danger with these kinds of tools, much like with LunaDoc, is the issue of permanence. Education is flexible and easily correctable, but treatments are forever. Or perhaps better said, contractual and transactional mistakes are often extremely expensive to fix, if they’re fixable at all.

While everyone knows how much of a fan I am of standardization, automation, and any tool (toy) that allows attorneys to avoid repetitive, boring tasks, the fact of the matter is that tech startups are not coffee shops, and startup contracts are not wills. As I’ve mentioned before, startup law is a multi-specialty, highly contextual sport.  There are countless tax, employment law, securities law, and other state law issues that might come into play in your particular context, some of which need to be handled in the contract, and others that are completely separate from it. Signing the wrong contract, or taking the wrong legal action, isn’t that different from taking the wrong pill.  The side effects may be serious, or even lethal.

But, wait, aren’t law firms themselves putting up these standardized forms? Read the terms of service, my friend. Zero liability. Their skin isn’t in the game. Just yours. Those are marketing tools.

Attorney-Directed Self-Help

There’s a slightly different approach that a few companies are taking to allow entrepreneurs to do some things themselves and minimize their legal spend, while ensuring that a professional who understands the context is guiding the process. Brightleaf has a brilliant concept called a Leaflet. After speaking with a client and understanding what they’re trying to do, an attorney can easily turn a form into a self-help, automated tool. For example, you can turn the Company’s board-approved Option Grant form into a leaflet that allows the client to input the name, date, etc., and auto-generate option grant forms without bothering his law firm. Of course, every time you generate a form, the attorney sees it. Self-help, but with an experienced and invested professional making sure you don’t blow something up.

VCExpert’s Private Company Analysis Tool (PCAT) allows a law firm to input and update a Company’s capitalization info, and a client can then run any number of reports using that data without having to consult the attorney. Again, someone’s there making sure the inputs are correct and that things don’t go awry, but the client doesn’t have to ask his attorney to generate a different report (often hours of work) every time he wants to see the vesting status of options or the funds flow of a potential exit.

Empowering clients and unlocking information from artificial silos is awesome. Pretending that technology can completely replace professional judgment and contextual understanding when it simply can’t… not so much.

Yes, I understand that self-help tools are really about the under/un-served.

Of course, downloading a free contract form drafted by someone who at least knew what they were doing is light-years better than issuing stock with a 3-line contract written on a napkin.  And that’s why I’m not going to say that un-guided self-help tools aren’t a benefit to the startup ecosystem.

Much like how cheap, mass-market contract websites have made wills and basic corporate forms available to people who would never have contacted an attorney to begin with, I get that there’s an underserved market here that needs these tools.  Just keep in mind that how much effort and expense you’re willing to incur in protecting your startup is, in many ways, a reflection of how seriously you take its prospects.  If you’re sitting on a dud, who cares if your employment forms aren’t enforceable in your state, or if you didn’t fill out your stock issuance forms correctly? But if you think it’s a home run (and why would you waste your time on something that you think isn’t?)… well, you get the idea. Investors will too.