Startup Law 101 Series – Tips from a Lawyer on Becoming a Founder

I have worked with thousands of founders and entrepreneurs in Silicon Valley since 1984. Here are a few suggestions I have to those thinking about becoming founders.

First, why become a founder?

1. Success as a founder will let you make more than you would otherwise make as an employee.

The multiplier effect of being in business makes this possible.

Your dad might have conceived a brilliant invention for IBM or HP and had a long and successful career making a steady salary there.

A salary is great but it is just a salary. It has obviously limits because an employer will rarely allow an employee to share in the multiplier effect that a successful innovation can have on a company’s business. The iPod will enrich Apple. It will not enrich the individual engineers who worked on it. The employees who contribute will be rewarded but only within the rigidly fixed bounds that salaried compensation affords (stock options can enlarge this somewhat but, again, within the obvious limits afforded by small option grants).

This is the single most important reason for most people to become founders. They want the large upside that will come from a successful venture. Successful venturing is very hard to achieve. When you do so, the rewards can be large. Nothing new here, of course, but worth repeating.

2. Success as a founder will let you keep more of what you earn.

If you are an employee, you have a target on your back and the taxman is taking aim at you.

Forget the rhetoric about making the rich pay all the taxes. The taxman is after you. Already, you pay federal and likely state income tax on your earnings, possibly even local income tax as well, at rates of at least one-third your compensation. Add payroll taxes to this and there goes another 10% or so. Lift the cap on social security taxes and it will be worse. Add assessments for future health programs that are in the works and the picture is a grim one for someone who is planning on earning salaried compensation over the next decades. No judgment here on the government programs. Just don’t believe anyone who says they are free. They are not and those with a target on their backs (i.e., employees) in particular will be taxed more and more heavily to pay for them in the future.

If you are a founder, you will undoubtedly draw salaried compensation over the years from any venture that proves successful.

But your largest reward by far will come eventually from a liquidity event at which you cash in your chips.

It is at that stage that you can normally get long-term capital gains treatment for the vast part of the economic gain you derive from your venture.

With capital gains, the tax you pay is much lower than for that for ordinary income. Lower income tax rates. No employment taxes at all.

With capital gains, you can often control the timing of when your gain is realized and this affords planning opportunities that can help further minimize the ultimate tax you pay.

It all comes from the same effort. You sweat for what you earn. As a founder, you convert much of your sweat from ordinary income into equity gains. With success, you not only can earn more but you can keep much more as well.

3. Being a founder can be not only a financially rewarding experience but a thrilling one as well.

We all need fulfillment and meaning in our lives and money will rarely if ever provide this in itself.

When you venture out, you get not only the chance to earn great financial rewards but also the opportunity to realize a vision you have for your company.

It might not be an earth-shaking vision. But it is yours. And it can benefit others. Your co-founders. Your investors. Your employees. Your customers. The public generally. Who knows?

There is just a plain excitement that comes from trying to build something that is new and different and successful. You don’t get this in anywhere the same measure as an employee.

Yes, you have lots of entrepreneurial risk. But this excitement is part of your entrepreneurial reward. It is a great reward if your venture succeeds. It is not to be underestimated. In the end, it may be your greatest reward.

Now, what does it take to maximize your chances of becoming a successful founder? Here are a few thoughts on this important subject.

1. If you are going into business for yourself, you need to build from strength.

Normally, get a strong education and excellent training working for others in your field before venturing out on your own. Master your craft. Build relationships. Be alert to how what you do might be done better. That is the key to innovation. This is the best path for most founders.

Do not venture into an unrelated area just because you are tired of what you do for a living. That idyllic little tea shop will become a financial bloodbath for you unless you really do know something about running a tea shop as a business. Don’t go into a business just because it sounds pleasant. Know what you are doing first.

If you have natural entrepreneurial skills, you can go into an unrelated business if you can plug into a setup where the unrelated-business expertise is provided for you. Go ahead with that restaurant franchise deal if it looks good for you, even though you are an engineer. Partner up with that expert team to which you can bring specialized skills, albeit ones from a different field. But do this sort of thing carefully. It is higher risk than if you know the field into which you are stepping.

Don’t venture out on your own on the strength of a bare idea. During the bubble, I would hear things like this: “I have worked one year for a manufacturing company and I know how to change the whole world of manufacturing through an idea I have for a website.” This sort of approach to venturing out is almost a guaranteed recipe for failure.

If you are a <i>wunderkind</i> entrepreneurial type, with exceptional natural talent, you will not be bound by any arbitrary formula for how to build from strength.  You will still be building from strength but that strength will be an exceptional entrepreneurial talent. Assess this one carefully, though. It is only the rare person who fits into this category.

2. Count the cost before you venture out.

You need to be temperamentally suited to go into business for yourself.

Don’t romanticize the process. Business is tough. You will lose the certainty of a regular paycheck. You will have bills to pay, whether or not you are making money. You will face a non-stop array of challenges, everything from people issues to financial pressures to competitor challenges to huge psychological pressures to all manner of obstacles. When you get past all of this, or at least most it, you will have build “good will” – that is, a going concern value for your venture. Good will is really nothing more than the advantages you gain from the blood you have spilt. It is a huge plus that means your business is better than others. But you will have to spill blood over it. Understand this up front and be prepared to pay the necessary costs.

It follows, of course, that if you are not ready to pay the costs you should stick with the steady job.

3. When you launch, try to do so with a multi-talented team.

There is no fixed rule here.

Experience confirms, though, that a team will be far more likely to succeed than will a sole founder.

This may be just another way of saying that, if something is truly good, others will be drawn to it.

More likely, it is another way of saying that launching and building a successful venture is extremely hard to do. If you bring exceptional engineering talent to the venture, but lack entrepreneurial skills, you will be much less likely to succeed than if you can team up with others who will provide those skills.

4. Make sure you have an intelligent business model.

Fine technical innovations are great. Far more often than not, though, they cannot sustain a venture.

In rare cases, the innovation will be so excellent (and usually patentable) that it can be sold or licensed to a large company in the relevant field or it can become the basis of a company whose assets are sold to a large company. Nothing wrong with any of that.

But, in almost all cases, technology itself is not enough. It <i>must</i> fit into a sound business model that will allow your company to build and sustain a meaningful competitive advantage.

If you can’t do that, your efforts will be wasted. You will not likely get funded in any meaningful way. Even if you do, that funding will likely be wasted.

5. Watch your expenses.

Wasteful spending is perhaps the single biggest fault of early-stage companies.

Small business entrepreneurs have far less difficulty with this than do startup founders. Why? Because they usually are dealing with own money. If you know what it took to earn it in the first place, the odds of your being profligate with it are greatly reduced.

One aspect of wasteful spending is simply extravagance. You get funded and you go out and get the best that money can buy. Expensive offices. Extravagant salaries. Lavish parties. And on and on. In early-stage companies, you will regret such spending when you hit the bumps in the road where you wish you had that cash. Inevitably, you will hit such bumps. Plan accordingly.

Another side to wasteful spending, though, comes from not focusing your efforts properly in the early stages. You have ten great things you want to do as a company. You don’t make good judgments about which of these to focus on. You spend on all of them. In short order, your funds are dissipated before you can build a reasonable revenue stream.

Use good judgment about where you can best use your limited funds and use them wisely.

6. Plan your legal roll-out carefully.

Don’t front-load unnecessary legal expenses.

When you are ready for a meaningful launch, though, do your setup properly.

If you have a founding team, make sure you give serious thought to using restricted stock as opposed to outright stock grants when making grants to founders. In other words, keep strings on the stock until it is earned unless there is some exceptional reason not to.

Use cheap stock to avoid tax problems.

Get the IP into the company.

Get employment and consulting agreements in place, making sure all IP from such arrangements goes to the company.

Review your trademark issues in connection with any branding you will do.

File provisional patents as applicable.

When you are ready to bring on a broader team, set up an equity incentive plan.

7. Fund your company incrementally where possible.

The worst trap an early-stage company can fall into is one where it gets over-extended.

Plan intelligently to avoid this trap.

Work with early-stage investors or have a reserve of your own funds to carry you through the phases before you have meaningful revenues.

Don’t put yourself in a position where you are out of options except for shopping your opportunity to VCs. You will either not get funded (the most likely outcome) or you will get slaughtered in the terms of the funding.

Being a founder can be a great experiences or it can turn into an unmitigated disaster. Evaluate yourself and your opportunities carefully before you venture out. It will be time well spent on your part. If it looks good, then by all means venture forth. There are worlds to conquer and time waits for no man.