Post Category → Formation

Should I form my Austin startup in Texas or Delaware?

Note: The DE-related info in this post is really applicable to startups based in any state, but I’m speaking mostly to Texas entrepreneurs, particularly in Austin, in writing this.  Because of the depth of startup activity in California, which might translate to more sophisticated case and statutory law, forming a non-DE startup there might make more sense than it would in Texas.

The default incorporation state in forming a company is always the state in which the company operates, but there are several reasons why a Texas startup (or any startup outside of California) might consider DE instead:

  • Well-Established, Business Friendly Statutory and Case Law – Because DE is the legal home of (by far) the largest number of large corporations in the country, you’ll find the least amount of ambiguity in DE as far as corporate governance practices, contractual interpretation, etc. are concerned.  And DE Chancery judges are by far the most knowledgeable in complex business matters of any judges in the country.  Virtually every corporate lawyer in the country who operates a serious practice will be familiar with DE law, so if you call him/her up with a random question about whether a certain transaction is kosher, or how a particular provision would be enforced in court, you’re 10x more likely to get a quick answer if you’re a DE corporation.  For a Texas entity, the answer will often be “I’m not sure,” which leads to “Let me research that for you,” and that research won’t be pro-bono.
  • Sophisticated Investors will expect Delaware – Because of the above, institutional venture capital firms that manage large funds will (very) often refuse to invest in a Texas startup that isn’t a Delaware corporation.  Angel investors are more likely to be OK with Texas, but we’ve encountered a fair amount of professional angels who either insist on DE before making their investments, or at least expect a conversion to a DE entity before the Company’s first venture capital equity round.
  • Protective of Officers and Directors – Delaware courts have a history of deferring to the business judgment of the officers and directors of a Company, meaning that without evidence of gross self-dealing or negligence, they’re unlikely to use hindsight to second-guess business decisions. This makes finding reputable executives and directors easier, for obvious reasons.
  • Response Time – Ever needed to close that bridge financing in the next 2 hours in order to make payroll? I’ve seen it plenty of times, but surely that would never be your company. Ever. Well, just in case, DE has an amazingly well-greased system for filing legal documents.  For extra fees, you can get guaranteed 24-hour, 2-hour, and even 1-hour response times. Suriname should really consult with the Delaware Secretary of State to up its game.
  • Converting Later is More Expensive – When you’re starting out fresh, there are no contracts to review, consents to get signed, etc. You just form the Company where you want to form it. But as time progresses, and you get shareholders, sign contracts, hire employees, etc., the amount of diligence involved in ensuring that you can convert to a DE entity grows exponentially. Pay now, or pay more later.

The Downsides to DE:

  • Fees (Cost): This is really the only reason why a Texas startup that intends to eventually raise professional venture capital will consider not incorporating in DE.  By forming a DE entity that operates in Texas, you’ll have to file a form to qualify to do business in Texas as a “foreign” (non-Texas) entity. This costs about $750. You’ll also need to maintain a “registered agent” in DE, which will run you about $125 a year. Finally, you’ll have to pay franchise taxes in both DE and TX, although the added cost until your startup becomes profitable is likely to only be a few hundred dollars a year.

So the decision to incorporate in TX or DE really boils down to two questions:

Do you ever intend to raise professional venture capital?

If not, then unless you just find Delaware’s sophisticated business-friendly environment really appealing, you’re probably well-served by sticking with a Texas/home state entity.  A lot, if not most, startups will fall into this category. Save your money and use it to build a great product.

If you do intend to raise professional venture capital, are you willing to incur the additional cost of forming a DE entity?

At formation, the up-front cost differential between a DE v. a Texas entity is likely to be about $1,000, with a few hundred extra a year for registered agent services and franchise taxes.  As time progresses, the cost of converting to DE will increase in terms of legal diligence and logistics as you execute contracts, pick up shareholders, etc. While numbers obviously vary, you can probably expect about $5K-10K in fees in converting your TX entity to DE pre-Series A.

Most of our clients bite the bullet and pay the extra ~$1K to form in DE from the beginning. That’s because (1) we don’t really serve startups that don’t intend to raise professional capital, because they don’t need us, and (2) it sends a signal from the beginning that the Company intends to operate in the big leagues. Still, a handful take the approach that 5-10x in fees is fine down the road if, at least at that point, they’ve found investors or a good revenue stream to help pay the costs.  I generally say that, if you’re really that worried about losing $1,000 in a startup that you seriously think will pursue venture capital, perhaps you should reconsider entrepreneurship altogether.  But it’s ultimately a personal judgment call.

What’s my startup’s stock worth?

Stepping back a bit from current events and meta issues, let’s talk about something more mundane, but nevertheless frequently asked by startup founders. What’s my stock worth, and why should I care?

Categories: I’d say there are three different types of “worth” that could be discussed here:

(1) worth to you,

(2) worth to others (what they would pay), and

(3) fair market value (FMV).

From an economic perspective, (1) and (2) are the most important.  But from a legal perspective, (3) is the one you should care the most about. Think of FMV as something related to, but conceptually distinct from, what others think the stock is worth. And to be as absolutely straight-forward and jargon-free as possible as to why you should care about it, one word: taxes.

Why should I care?

A. Taxable Gain

First, virtually any time that someone gets stock with a fair market value above what they paid, that’s taxable gain. Naturally, whenever possible, you want to ensure that when you issue someone stock or options, they aren’t also being handed a tax bill with it. Unfortunately, the IRS doesn’t let you pay your taxes with options. Equity in your hand + cash out of your wallet = bad.

B. Regulatory Compliance

Second, with the understanding that promoting equity incentives can be valuable to companies and the economy as a whole, the IRS has provided some safe harbors (of sorts) through which you can issue options to employees while being able to defer taxes down the road, preferably around the time of a liquidity event (cash in your hand to pay that tax). Your attorney can discuss details with you in more detail, but the most important one for purposes of this discussion is: the exercise price of the option needs to be at fair market value.

C. Key Relationship between (1) and (3)

Notice the key relationship between (1) the value that you place on your stock and (3) fair market value. To the extent FMV is below what you and your employees view (subjectively) as the value of your startup’s stock, you’re able to give something that, at least to you and them, is worth more than what needs to be paid to avoid taxable gains. If FMV for tax purposes is $0.50 per share, but to me the stock is worth $2.00, I can pay $0.50 per share, get $1.50 worth of (subjective) gain, and not pay tax.

Nutshell: a low FMV relative to subjective value is a good thing.

So what’s the fair market value of my startup’s stock?

It depends.

Never Sell Common Stock in an Outside Financing

The number one determinant of FMV is always (2) in the above list: what people are willing to pay for it. If/when the IRS chooses to look back at the FMVs you applied to your stock, that will be the first thing they look for. This is precisely why any competent startup lawyer will tell you that, while Common Stock is good for founders and equity incentives for services, you should almost never sell Common Stock in a financing. This will likely “taint” the FMV of your Common Stock, and effectively force you to set a significantly higher FMV for your stock options than you otherwise would have to. For that reason, it’s almost always recommended to do a financing either through preferred stock or convertible notes that will eventually convert into preferred stock. Because preferred stock has various preferences/privileges that Common Stock does not, you can sell preferred stock for, say, $2.00 per share, while still making a credible claim that the Common Stock is worth a fraction of that.

At Formation

So how is it that founders and early employees are able to get millions of shares in their startups for practically nothing, without being taxed? Simple. At formation, the FMV of your startup’s stock is considered virtually nothing. Now, it’s certainly not worth nothing to you. But because you haven’t built an actual Company yet, the IRS accepts the argument that the huge amount of uncertainty and risk of failure make the stock worth fractions of a penny.

We generally issue founder stock at a price per share equivalent to par value (usually $0.0001 per share). So an issuance of 2,000,000 shares to a Founder would require a check for $200.00. Assuming that founder files her 83(b) election (bad news if she doesn’t), she won’t realize taxable gains until she decides to sell her stock.

Note that this is also an argument for getting your founder shares and early employee equity issued as soon as possible.  The further along in your Company’s trajectory that you are (customers, revenue, investors), the greater likelihood that your Common Stock will have a higher FMV, and that the recipient will need to hand over meaningful cash either to you or the IRS in order to receive it.

After Formation, Financing

After formation, and as you move into seed funding, setting the fair market value of your Company’s stock becomes much more complex. Section 409A of the Internal Revenue Code is largely what drives that complexity, which this post is not meant to cover. The nutshell is that before a full venture capital financing, your lawyer will recommend that your Board of Directors use various “illiquid startup” guidelines to set the FMV of your stock.  After a VC financing, you’ll likely get a formal 409A valuation from a bank or valuation firm, and use that to set the exercise prices of your options. There are a number of reputable valuation firms in Austin that we recommend to our startup clients, and, as with hiring a lawyer, you should be careful about going with the firm that offers the lowest price. That can come back to bite you.

Take-home message:

  • FMV is related to (but not the same as) your or a potential investor’s value of your stock.
  • Issue equity and equity incentives as early as possible to avoid taxable gains.
  • To avoid “tainting” the FMV of your Common Stock, never sell Common Stock in a cash financing.
  • Consult with your attorney about setting the FMV of your stock as your company progresses.

Obligatory Disclaimer: I know you’re smart enough to know this, but this is not tax or legal advice. Things might be different in your particular context. Contact a professional before making a decision you might regret.

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.

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.