FAQ for Entrepreneurs
You are an entrepreneur and about to start a new business. Or maybe you are already selling your product or service to several customers. How do you make sure you have set up the appropriate legal entity, prepared for fundraising and are ready for an exit?
Q: Which entity should I form?
A: It depends on what your goals are for the business. If you envision a mom-and-pop laundromat, then an LLC might be the right entity for you, but if you intend to raise capital from professional investors, then a Delaware C corporation is more likely the better entity.
Young entrepreneurs tend to gravitate to the LLC because of flow through taxation and liability protection, but they don’t realize that there are downsides to LLCs. For example, incubators and venture capitalists generally insist on investing in Delaware corporations. Also, LLCs don’t benefit from Section 1202, which applies to corporations, allowing certain stockholders a ten-million-dollar tax free gain.
Q: Which state(s) should I incorporate in?
A: If you start your business expecting to raise money from professional investors, then you should incorporate in Delaware. But, if you have already incorporated your business in another state, there is no sense reincorporating in Delaware until an investor asks you to do so. Delaware is the top choice for US investors because Delaware corporate law is well understood by most corporate attorneys and has been thoroughly litigated, resulting in more predictable outcomes and less uncertainty in a legal dispute.
You are also required to register your business in any state where you have “nexus.” Nexus can mean different things depending on a particular state’s laws, but generally you are required to register your business in the state where your principal office is located, and where you are deemed to be doing business.
With that being said, registering in multiple states when not required creates administrative headache and cost. So, limit your filings to where you are required by law or by your investors.
Q: How many shares should I authorize?
A: For most of our startup clients we recommend authorizing 10 million shares and issuing the founding team around 8 to 8.5 million of those shares. The remainder is typically reserved for an employee and advisor equity incentive plan. It is important to remind new entrepreneurs that you own 100% of a business when you authorize 10 million shares but only issue yourself 8-8.5 million because ownership is based on issued shares and not authorized shares.
We recommend only authorizing 10 million shares and focusing on percentages rather than quantity of shares. However, it is important to note that the Delaware franchise tax is based on either authorized shares or gross assets. Startups should be aware that they can minimize their franchise taxes by calculating their tax as a function of total assets rather than by the number of authorized shares.
Q: What are the different ways to raise capital?
A: Generally, you can raise capital through a Simple Agreement for Future Equity (SAFE), a convertible note or the sale of common or preferred shares. When an entrepreneur raises money through a SAFE or a convertible note it is generally called a friends and family round or an angel round. When an entrepreneur secures initial equity funding through the sale of shares it is usually considered a Series Seed financing. We usually recommend startups raise money through a friends and family or an angel round before ever issuing any shares in order to prevent ownership dilution of the founders at too low of a valuation. This approach allows entrepreneurs to delay the valuation discussion to when value has been created.
Q: What are key issues with raising capital through a SAFE or a convertible note?
A: We see entrepreneurs raising capital through commercial loans, convertible notes or SAFEs. We generally advise clients to avoid commercial loans (assuming they are even available at the early stages) because banks tend to require entrepreneurs to personally guaranty the loans. Convertible notes and SAFEs are good early vehicles for raising money because the entrepreneur receives an immediate investment in exchange for a future obligation to issue preferred stock in a preferred financing.
SAFEs were created by the incubator Y Combinator as a way for entrepreneurs to raise money quickly with minimal associated legal costs and avoid shortcomings of other investment vehicles. If an entrepreneur uses a SAFE to raise money, we suggest sticking to the desired Y Combinator form and pushing back against any investor who wants to modify them or otherwise have the company agree to third-party terms in a side letter. However, Y Combinator does have a pro rata form side letter which is customarily entered into in connection with a SAFE.
An item to consider for SAFEs is there are different versions depending on the terms being offered by the investor. In addition, you should also understand the difference between the use of a pre-money vs. post-money SAFE. The current form of SAFE is post-money, which means that the investor will be guaranteed a fixed percentage ownership of the company immediately prior to the next financing round. We recommend entrepreneurs run pro forma capitalization table scenarios to fully understand the dilutive effect of the post-money SAFE before using it to raise capital.
Convertible notes are less frequently used than SAFES, as they constitute debt with an interest component and a maturity date (unlike a SAFE), but typically convert on a pre-money versus post-money basis.
Another consideration with either a convertible note or a SAFE is that the parties will generally agree to a valuation cap, which is protection for the investor if the company’s valuation in the subsequent equity raise is higher than the valuation cap. For example, if an investor buys a $1M convertible note or SAFE with a $9M valuation cap, and then the company undergoes a Series Seed financing at a $10M valuation, the note or SAFE holder will convert into an amount of Series Seed preferred shares based on the lower $9M valuation even though the new money investors are paying for their shares at the higher valuation. For early stage companies, the typical valuation cap range is $4M to $10M, although founders with prior exits, with compelling domain experience and/or participation in reputable incubators can significantly increase the higher end of the valuation range.
Q: When am I ready for institutional investors?
A: We recommend that entrepreneurs raise anywhere between five hundred thousand to two million dollars through convertible notes or SAFEs before issuing equity because it allows the company more time to prove itself (and thus drive a higher valuation) before negotiating a term sheet for the sale of equity.
Kit Ryan is an associate located in Pillsbury's San Diego office.
Q: Which entity should I form?
A: It depends on what your goals are for the business. If you envision a mom-and-pop laundromat, then an LLC might be the right entity for you, but if you intend to raise capital from professional investors, then a Delaware C corporation is more likely the better entity.
Young entrepreneurs tend to gravitate to the LLC because of flow through taxation and liability protection, but they don’t realize that there are downsides to LLCs. For example, incubators and venture capitalists generally insist on investing in Delaware corporations. Also, LLCs don’t benefit from Section 1202, which applies to corporations, allowing certain stockholders a ten-million-dollar tax free gain.
Q: Which state(s) should I incorporate in?
A: If you start your business expecting to raise money from professional investors, then you should incorporate in Delaware. But, if you have already incorporated your business in another state, there is no sense reincorporating in Delaware until an investor asks you to do so. Delaware is the top choice for US investors because Delaware corporate law is well understood by most corporate attorneys and has been thoroughly litigated, resulting in more predictable outcomes and less uncertainty in a legal dispute.
You are also required to register your business in any state where you have “nexus.” Nexus can mean different things depending on a particular state’s laws, but generally you are required to register your business in the state where your principal office is located, and where you are deemed to be doing business.
With that being said, registering in multiple states when not required creates administrative headache and cost. So, limit your filings to where you are required by law or by your investors.
Q: How many shares should I authorize?
A: For most of our startup clients we recommend authorizing 10 million shares and issuing the founding team around 8 to 8.5 million of those shares. The remainder is typically reserved for an employee and advisor equity incentive plan. It is important to remind new entrepreneurs that you own 100% of a business when you authorize 10 million shares but only issue yourself 8-8.5 million because ownership is based on issued shares and not authorized shares.
We recommend only authorizing 10 million shares and focusing on percentages rather than quantity of shares. However, it is important to note that the Delaware franchise tax is based on either authorized shares or gross assets. Startups should be aware that they can minimize their franchise taxes by calculating their tax as a function of total assets rather than by the number of authorized shares.
Q: What are the different ways to raise capital?
A: Generally, you can raise capital through a Simple Agreement for Future Equity (SAFE), a convertible note or the sale of common or preferred shares. When an entrepreneur raises money through a SAFE or a convertible note it is generally called a friends and family round or an angel round. When an entrepreneur secures initial equity funding through the sale of shares it is usually considered a Series Seed financing. We usually recommend startups raise money through a friends and family or an angel round before ever issuing any shares in order to prevent ownership dilution of the founders at too low of a valuation. This approach allows entrepreneurs to delay the valuation discussion to when value has been created.
Q: What are key issues with raising capital through a SAFE or a convertible note?
A: We see entrepreneurs raising capital through commercial loans, convertible notes or SAFEs. We generally advise clients to avoid commercial loans (assuming they are even available at the early stages) because banks tend to require entrepreneurs to personally guaranty the loans. Convertible notes and SAFEs are good early vehicles for raising money because the entrepreneur receives an immediate investment in exchange for a future obligation to issue preferred stock in a preferred financing.
SAFEs were created by the incubator Y Combinator as a way for entrepreneurs to raise money quickly with minimal associated legal costs and avoid shortcomings of other investment vehicles. If an entrepreneur uses a SAFE to raise money, we suggest sticking to the desired Y Combinator form and pushing back against any investor who wants to modify them or otherwise have the company agree to third-party terms in a side letter. However, Y Combinator does have a pro rata form side letter which is customarily entered into in connection with a SAFE.
An item to consider for SAFEs is there are different versions depending on the terms being offered by the investor. In addition, you should also understand the difference between the use of a pre-money vs. post-money SAFE. The current form of SAFE is post-money, which means that the investor will be guaranteed a fixed percentage ownership of the company immediately prior to the next financing round. We recommend entrepreneurs run pro forma capitalization table scenarios to fully understand the dilutive effect of the post-money SAFE before using it to raise capital.
Convertible notes are less frequently used than SAFES, as they constitute debt with an interest component and a maturity date (unlike a SAFE), but typically convert on a pre-money versus post-money basis.
Another consideration with either a convertible note or a SAFE is that the parties will generally agree to a valuation cap, which is protection for the investor if the company’s valuation in the subsequent equity raise is higher than the valuation cap. For example, if an investor buys a $1M convertible note or SAFE with a $9M valuation cap, and then the company undergoes a Series Seed financing at a $10M valuation, the note or SAFE holder will convert into an amount of Series Seed preferred shares based on the lower $9M valuation even though the new money investors are paying for their shares at the higher valuation. For early stage companies, the typical valuation cap range is $4M to $10M, although founders with prior exits, with compelling domain experience and/or participation in reputable incubators can significantly increase the higher end of the valuation range.
Q: When am I ready for institutional investors?
A: We recommend that entrepreneurs raise anywhere between five hundred thousand to two million dollars through convertible notes or SAFEs before issuing equity because it allows the company more time to prove itself (and thus drive a higher valuation) before negotiating a term sheet for the sale of equity.
Kit Ryan is an associate located in Pillsbury's San Diego office.