Subscribe
Share
Share
Embed
Conversations with business leaders and changemakers on how they built their business and what keeps them going.
Pankaj Raval (00:00)
All right, ladies and gentlemen, welcome back to Letters of Intent. I am Pankaj Raval, your co-host and founder of Carbon Law Group. And today I'm joined by none other than Sahil Chaudry, my co-host. Sahil, how are you today?
Sahil (00:10)
Great. For everyone who doesn't know, I'm Sahil Chaudry, corporate attorney here at Carbon Law Group.
Pankaj Raval (00:15)
Yes. And Sahil, today we are going to be talking about a topic that has come up quite a bit over the years of practice. And that is related to our work with early stage founders and helping them structure companies. A lot of people will nowadays be going online to clerky or legal zoom to create their entity. But we're seeing a lot of problems here and people come to us hey, help me fix this a lot because they didn't think about things that they should have really addressed.
when they're structuring the company. And it turns out that maybe these formations don't always work for every situation. today we're gonna talk about some of the biggest mistakes we see founders and early stage companies making, you're an entrepreneur or maybe an early stage company growing. We see these issues all the time and people come to us and it costs a lot more to fix it rather than doing it the right way the first time.
so Sahil, today we're gonna be talking about a topic that is really important to lot of our clients and that is structuring the entity the right way from the beginning. And we see a lot of bad structuring, a lot of people coming to us with the wrong approach to their business that causes them a lot of problems the line. So from your perspective, what's one of the biggest issues or some of the biggest issues you see with founders who have
not really taking the proper steps to structure their entity the right way.
Sahil (01:25)
Well, there are a lot of issues, but right off the bat, when our clients use our registered agent to do their formation, I almost always see that a number of shares have been authorized that the founders don't know. They don't know how many shares have been authorized. They don't know what type of shares have been authorized. And in almost every case, those shares have actually not been issued by the time that founder wants to
raise additional capital in their company. Just to make a little bit of an easier example for our listeners here, when you use a registered agent and they form a corporation, that corporation is authorizing shares, but it hasn't issued those shares yet. And so for you to your own shares in your company,
Those shares have to be issued to you in some way, either because you purchased them or they've been awarded to you for other reason, maybe because of your services. But that paper trail has to happen. And ultimately, there are going to be some.
matters where you need stockholder consent in order to bring new capital on. Let's say you need a stockholder consent to approve the purchase of additional shares or you need to spread out the shares and identify who owns what. You can't issue shares to an investor before you've issued shares to yourself. So that's one issue that we really see often is at Formation is founders not knowing that they haven't issued shares to themselves. The second
Pankaj Raval (02:38)
Thanks.
Sahil (02:45)
major issue I see is many of our founders are unfamiliar with the SEC rules. And even if you're offering one share or one unit to investor or a service provider, someone who's going to be working for you and wants equity or someone who's going to invest in your company.
you are going to need to fall under one of the SEC's Safe Harbor regulations that allows you to offer those shares without SEC registration.
And so, D, there's 4A2, there's 701. There are regulations that are really important. I mean, I can't tell you how many times we speak with clients who say, But it was just one share, but it doesn't matter. Even if it's just one share, you need to follow the rules for how you're issuing that share. And the third I see that happens at formation,
is not really knowing how you're gonna pay People don't realize that there's one way you could pay yourself is through your shares, but more often than not, you're gonna wanna pay yourself a salary or some kind of guaranteed payment, some kind of recurring source of revenue that you're gonna wanna collect. And those are different things. Collecting
your shares or from your units, meaning collecting a distribution or a dividend or collecting payment like a commission from a 1099 or collecting a salary from a W-2. Those are all very different things and those have to be worked out.
And finally, I want to highlight the sources of authority in a company or corporation. So in an LLC, which is a very commonly used, you have a board of managers or it's member managed, but deciding between those two is very important. You need to know who's making decisions. and you need to know who the owners are, which are the members in an LLC, because that determines who's going to elect the managers or if they're going to make the decisions themselves.
Alternatively, if you have a corporation, you need to decide who's going to be on the board of Pankaj, we often advise founders to not go with a two-member board because that can result in a deadlock or a stalemate.
And then we want you to understand, one thing that we like to advise our clients of is how do these sources of authority flow? So when it comes to stock, there are certain decisions that are reserved to the stockholders. If you hold the majority of stock or maybe sometimes unanimous approval, the stockholders vote in the directors. The directors make major decisions, but then they reserve some decisions to the officers, the president, the secretary and the treasurer. And
in a corporation, have to appoint those officers. So these are categories that upfront, if we decide how we want to handle them, everything goes way more smoothly for the founders and for your future investors.
Pankaj Raval (05:20)
So, that's interesting, Sahil. There seems like a lot that you have to think about forming a company. And if I'm a founder thinking about starting a company, what are some of the initial questions I should be thinking about? What are questions I should be asking when I'm setting up this company?
Sahil (05:31)
Well, I would start from the stock or the ownership interest. So if you're doing an LLC or you're doing a corporation, you're gonna have units or you're gonna have shares. I would start with how much of that company or corporation are you going to own at Formation? How much do you wanna make available to additional stockholders?
Also, I would ask is this company intended for an exit or is this supposed to be for recurring revenue? If you're going for more recurring revenue, I'd go with an LLC because you're going to have pass-through taxation and that is going to benefit you because you're going to be collecting money every month. If you're going for a big exit, you want to go with a C Corp so you're going to benefit from QSBS. I would ask who's on your board of directors? good.
Pankaj Raval (06:12)
⁓ What about a S-Corp? What
about an S-Corp?
Sahil (06:14)
Absolutely, an S-Corp is great. If you're a small business, especially if you're a single owner, you're a one person owner, that's really beneficial because you can avoid self-employment taxes and pay yourself a salary. And then you can allocate a larger share of your compensation to an equity dividend.
And so yeah, an S-Corp is great. You get limited liability. The only thing that there is a problem with S-Corps though, which is that you cannot take money. You cannot get investment from a non-individual and you cannot take money from any foreign individual. And there's a limit to how many shareholders you can have. You have up to a hundred shareholders. So there are some real limits to having an S-Corp, but it works really well for small
are not planning on a major exit, they're looking for a cash flow business, and even if they're looking to raise money, they're looking to raise money from individuals.
Pankaj Raval (07:04)
Nice, okay, so let's say I'm founder, I got an AI company I'm super bullish about, we wanna raise money, we want a big exit. What do you suggest on how I approach structuring? What do I need to do to set up my company?
Sahil (07:16)
So what we would recommend if you were one of our clients is doing a C Corp because if you're doing a tech company, that means you're anticipating a major exit. Usually tech companies are formed because of their potential for scalability. So what we would do is form a C Corp. 10 million shares is most likely what we would authorize. We'd want to issue something like 8 million shares to the founder or the founders.
then we want to reserve approximately a million shares for an ESOP, an equity stock employment program. And then we'd want to reserve 1 million shares for the future to make sure that we understand where the cap table is on a fully diluted basis. Then what we would advise is either you're the sole director or if you're going to have directors on board with you,
that you pick directors or at least as initial directors, directors that you trust who are gonna help you guide the business. And then you would need to select your officers. Who's gonna be the president, treasurer, secretary. These are required positions that you have to include in your documents for Delaware.
Pankaj Raval (08:15)
Interesting. So, Sahil, let's say, I have a founder, I have two other founders. We say, let's 33, 33, 33, 33. Does that make sense? Is that something we should just do?
Sahil (08:23)
I think that
can work. You can go 33 33 33. The you'll have to determine do you make all of your decisions together or
And when you say 33, 33, 33, does that apply to equity and stock? Or does it apply to decision making on the board? Does it apply to officer positions? Most likely when someone says that, they mean equity. And that translates to who's on the board very often. But.
Pankaj Raval (08:46)
Mm-hmm.
Sahil (08:50)
In that model where two-thirds can be a majority and vote to create decisions, that would be fine. If two people though are going 50-50, we would raise a red flag and real potential for stalemate here and you need to build in some kind of controls to break stalemates.
Pankaj Raval (09:06)
Interesting, And I oftentimes hear founders talking about equity and percentages, but a risk of that, right? we wanna kind of, I generally try to have founders shy away from mentioning equity in context of percentages because don't percentages change?
Sahil (09:20)
Absolutely, percentages change. As soon as you bring on another investor, that 33 % can go down to 30 % or 25%.
The percentages are never fixed. So even when you're buying into a company and they tell you the percentage that means it's the percentage either as of that date or it's the percentage upon a given event like some kind of triggering event so when you see someone offer you a percentage you have to know that that is Correlated to a point in time and that's not fixed and permanent. So you're right either we would use shares or we would use units at formation it doesn't feel like it makes a difference because
they're mirroring each other, but as you bring on more investors, that cap table is gonna change and those percentages are gonna change.
Pankaj Raval (10:02)
Yeah. And another big question, I think another big issue I see early on and I think a lot of where founders get stuck or don't or kind of gloss over is how do you even distribute equity to each person? Right. Who's bringing what to the table It is not not always an easy conversation, but an important conversation to have. Right. Because a lot of people default to say, hey, 33, 33, 33. But I think if you're not clear about what the expectations are at the beginning.
of who's doing what bringing what to the table. Maybe there's some IP being contributed. needs to be considered in terms of how you get to the number you're getting to. And I think if you don't really think about that in detail, it could lead to big problems down the line.
Sahil (10:39)
That's a great point. We've seen some people contribute money, some people contribute IP, some people contribute their services, and those all have to be valued proportionally and appropriately.
So yeah, absolutely. I think that that makes a big difference. And then, when you're offering equity, we always advise using restricted units or restricted stocks so that all the parties are incentivized to build up the company. Because often, if you get all the equity upfront, you don't have a lot of incentive
to help build the company outside of the company having a major exit, you being able to sell your shares. But we advise our clients to use restricted units or restricted stocks so that the incentives are aligned. Something like 25 % upfront or after a one year cliff, and then 75 % over either 36 months or 48 months.
Pankaj Raval (11:26)
Absolutely. That's a great point. And I think with vesting, which is standard for pretty much all equity issuances and expected from VCs, you want to make sure you're doing it. You're not just granting equity out front to everyone because, if things change in a year, you don't want people to hold that equity. So very important to listen to of the insights about vesting and and making sure that you have mechanisms to get equity back
in the event that someone leaves or something happens or someone doesn't work out, you need some contingencies there. And also, this is for a pro tip for anyone who's listened this long. This is super helpful. I've used this for our startups. I have a legal tech startup called Service that is launching soon. I've used this for our team. And it's great because it's very easy to understand calculators, saying, OK, who's doing what and who's bringing what to the table? And that helps you get to the number
should own what. So it's not just some kind of pie in the sky or what feels right. You're actually on some actual data. is just the start. There's actually other ways of doing this. If people want a more dynamic way of doing it, there is another option that we can get into in another date called, Slicing Pie. And Slicing Pie is kind of
unique and not as popular, because there has some complexities But it's a dynamic way of determining how much equity founders get based on the work they put into a company. So that it requires more tracking. But this is something also think about. I mentioned to other clients. I've actually met with the creator of this program, Slicing Pie. He's shared all his agreements with me. have a great tracker here.
It does require everyone tracking their a lot more, data to kind but it is probably more fair because you track based on what the inputs actually are. So this is just giving you an idea of here. There's a lot of different ways to determine what makes sense and how to split equity, but you've got to think about it. You can't just dial it in and say, okay, because we're a three people team, we should be 33, 33, 33. That's not the case. And everyone has unique skills that they bring
to a company and you need to have those conversations now rather than later.
Sahil (13:17)
I also want to touch on what we were talking about with the vesting. Most of our founders have at least heard of an 83B election. And the reason that that becomes important is if your shares are vesting, you want to lock in the nominal value of those shares upfront as opposed to when you would sell them later on when the shares are much more valuable and you'd have to pay tax on that higher basis. So we just want to flag that I would say that's another.
issue we see with our founders is failing to file an 83B election. So either you're issuing shares or units, restricted units or restricted shares to future investors or service providers, or you are the investor, you want to make sure that you file that 83B election so that you can capture that nominal value.
Pankaj Raval (13:59)
Yeah, exactly. so guys, there's a lot of information covered some stuff that is a little bit dense probably will take a little bit more discussion and future episodes. But we wanted to raise the issue here that, starting and structuring a company is not a simple check the that you can just simply do online and not think about. It does require thought. It does require analysis.
This is why I've been doing it for 15 years or more. We've been doing it for a long time because there are significant issues to address and think about in when creating a company, it and just creating a plain vanilla company, maybe a start, but it's not going to be for growth and really thinking about preserving your rights in the future. So if you guys have questions, if you have comments, concerns,
how you structure your company on how to do it right. Please let us know. We'd love to hear from you. us a like, comment, share on this podcast and we would love to hear from you. This is a really interesting subject, lots to talk about and lots more to dive into.
So until next time, thank you again for listening to Letters of Intent. I'm Pankaj Raval.
Sahil (14:59)
and I'm Sahil Chaudry.
Pankaj Raval (15:00)
and we'll see you next time. Happy deal making.