Three VC Tips Every Entrepreneur Should Know

Starting companies is hard. As one serial entrepreneur with many successes puts it, “Starting up a company is the absolute hardest thing I know how to do—it is also the most rewarding.”

With that said, it is critical to make sure that your company is pointing in the right direction from the moment it leaves the launch pad. Any misdirection or miscue on the basic organizational steps is likely to be fatal. It’s like launching a rocket aimed at the moon—if the launch is only 2 degrees off target at blast-off, it will miss by hundreds of thousands of miles.

Keeping this is mind, here are three basic rules that every company founder should take into consideration

1. Keep it simple.

In setting up the capital structure and the first equity of the company, many founders either try to innovate or try to accommodate the wishes and desires of every co-founder and early stage employee. The result is too much complexity. In most cases where there is more than one founder (probably on the order of over 80 percent of startups), the stock should be split equally. If it isn’t an even split, then you should re-evaluate whether your co-participants really deserve to be in the “founder” category. Establish uniform stock vesting provisions that apply equally to both founders (although maybe with some “credit” for pre-formation activities) and early stage employees. Stay away from unconventional employment terms that differ from founder-to-founder or employee-to-employee. Make sure your outside board members, or if you have an advisory board, your advisors are compensated equally. Etc., etc.

If you fail to keep the capital structure and the equity incentive arrangements absolutely vanilla-flavored, i.e., consistent with convention, then every investor you approach and every manager you hire will require an explanation. Stay focused on the business plan, not the infrastructure of the company.

2.  Choose the right business entity.

If you are planning on raising professional capital, whether from an angel group or from a venture capital firm, use a Subchapter C corporation incorporated in the State of Delaware. LLC’s don’t work—investors categorically will not invest in an entity that will require them to file annual federal and state tax returns to reflect the pass-through of operating gains and losses, as LLC’s do. Neither do Subchapter S corporations, if the fundraising process is likely to begin in the first year. Sub S companies are viable only with investors who are “natural persons” (which automatically is a problem with VC firms and most angel groups) and only where there is a single class of stock (i.e., not preferred stock, which is typically the class of stock given out to angels and VCs).

A Delaware corporation is the preferred choice among states to choose from—most law firms will recommend this for a number of reasons, not the least of which it will save you the expense of reincorporating to Delaware in the event you are successful enough to consider an IPO in some distant future. (Fun fact: some 70 percent of the U.S. publicly held companies today are incorporated in Delaware.)

3.  Wait until the time is right before forming your company.

Many founders are in a rush to go out and incorporate and set up the founders’ stock arrangements and stock plan as soon as they finish their executive summary and PowerPoint presentation in preparation for raising money. WAIT.

It doesn’t take much time to form and organize a company—maybe a couple of weeks at most if you follow Rule No. 1 above! There are maybe three general exceptions to this rule: (i) you have promised your co-founders and/or anticipated early stage employees with specific allocations of stock, and they are tired of waiting to get their hands on the stock certificates; (ii) you are about to enter into a contract with a strategic partner or a significant vendor or a major customer, and either they want to see a corporate entity on the signature line, or you are worried about potential personal liability if you sign as an individual; or (iii) you are HIGHLY confident you are going to get funded. Absent these circumstances, focus on the business.

Of course, there are many other matters that need to be addressed almost daily by any founder, but these three rules are good ones. They are likely to save you a lot of aggravation later on, and most importantly will enable you to keep your focus where it belongs—on your business plan, and persuading the investment community to see the potential in your company.

  • Collom

    Falconjournal: I can’t speak to the guidance offered in the course you mention. However, I do think that if you look across the tech/biotech landscape, you won’t find any venture-backed companies that are set up as LLCs. As I mentioned, VCs are not in the business of filing federal and state tax returns to reflect operating gains and losses, nor are they interested in reporting the operating performance of their portfolio companies to their limited partners. Whatever other benefits an LLC might offer to a growth-oriented startup, that particular form of entity is a non-starter as soon as venture capital appears on scene.

  • Collom

    Falconjournal: I can’t speak to the guidance offered in the course you mention. However, I do think that if you look across the tech/biotech landscape, you won’t find any venture-backed companies that are set up as LLCs. As I mentioned, VCs are not in the business of filing federal and state tax returns to reflect operating gains and losses, nor are they interested in reporting the operating performance of their portfolio companies to their limited partners. Whatever other benefits an LLC might offer to a growth-oriented startup, that particular form of entity is a non-starter as soon as venture capital appears on scene.

  • http://justindunham.net Justin Dunham

    One solution is to set up a C-Corp that the VC owns (thus avoiding UBTI etc.), and that C-Corp then invests in the LLC. C-Corps are painful for entrepreneurs as they significantly reduce after-tax return for them. Obviously VCs may not want to do this, then the question for the entrepreneur is whether it’s worth it to them to be double-taxed in order to get money.

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