By Richard Harroch and Mike Sullivan
With our combined years of experience in startup law, entrepreneurship, and venture capital, we are often asked the following questions by entrepreneurs who are seeking to start a technology company. Sometimes there isn’t an easy answer to these questions, and as lawyers often like to say, “It depends on the circumstances.” But here are our shorthand answers to the most frequently asked tech startup questions:
1. Should I form my tech company as a C corporation, an S corporation, an LLC, a partnership, or a sole proprietorship?
Start it as a C corporation, unless you can really use the tax deductions that you will get from the losses of the business in an S corporation or LLC. General partnerships and sole proprietorships are to be avoided because of the potential personal liability to the owners of the business. C corporations are the only form of business that can qualify as “qualified small businesses,” which may help you avoid some capital gains down the road. Venture capital investors typically won’t invest in an LLC and usually expect to invest in a C corporation.
2. Where should I incorporate my business?
The standard answer to this is Delaware because of its well-developed corporate law. Venture capitalists have a strong preference for Delaware, in part because they’re familiar and comfortable with the rules of the road for Delaware corporations. You will often save on legal costs with Delaware, because most legal forms for tech companies are set up for Delaware corporations. However, sometimes the right answer is that it should be the state where the business is located, as this will save you some fees and filing complexities.
3. How much should I capitalize my business with at the beginning?
As much as you can reasonably afford, and in an amount that will carry you for at least 6-9 months with no income. What you will likely find is that it always takes you longer to get revenues, and that you will incur more expenses than you anticipated.
4. How likely will it be that my tech startup can get venture capital financing?
Very unlikely. Develop a viable product, gain some traction in the marketplace, hire a good management team, and then consider pursuing venture financing. Your initial financing will likely need to come from family, friends, or angel investors. Venture investors often want to see meaningful traction in product development, sales, and marketing before they consider investing.
5. Should I require prospective angel or venture capital investors to sign a Non-Disclosure Agreement (NDA) so they don’t steal my idea?
No, don’t waste your time. It will be counterproductive and slow down your fundraising. Most investors will either refuse, or assume that you are unsophisticated for even asking. It’s hard enough to get a meeting with an investor—don’t put another roadblock in the way. For the most part, it’s not the idea that is important; it’s the implementation of the idea, progress in implementing the idea, and the expertise of the entrepreneurs behind it.
6. How much dilution in share ownership of my company should I give up to investors in my business?
Whatever amount gets you funded. Don’t try to over-optimize on ownership. Of course, you should try to minimize dilution to the extent possible, but the important thing is to get cash to grow your business and make your investors happy as well.
7. How big should a stock option pool for employees be?
Typically, it should be 15-20% for early-stage companies. Standard vesting for options is four years, with a one-year “cliff vesting” and monthly vesting after that. “Cliff vesting” in this context means the employee must be employed by the company for a minimum of one year before the employee earns any of the options.
8. How can I get a venture capitalist to pay attention to my tech startup?
Any of the following:
- Get a ton of traction in the marketplace.
- Be able to show meaningful growth in revenues.
- Assemble an experienced management team.
- Develop truly innovative technology with a big market opportunity.
- Get a personal introduction to one of the VC firm partners from a respected colleague.
9. How can I come up with a great name for my tech startup?
This can be challenging. First, brainstorm a bunch of different names. Then do a Google search to see what is already taken, which will probably eliminate 95% of your choices. Make the name easy to spell. Make it interesting, but don’t pick a nonsensical name that won’t give people a clue as to what your company does (with all due respect to Google and Yahoo). Do a trademark/tradename search on the name, then make sure you can get the domain name. Don’t pick a name that could be limiting as your business purpose expands. Lastly, make sure you and your employees will be happy saying the name. For more advice on this topic, see 12 Tips for Naming Your Startup Business.
10. What are some of the challenges to starting a tech company?
- Coming up with a great and differentiated product or service
- Securing sufficient funding and maintaining reasonable cash reserves
- Having a great investor pitch deck
- Sticking to it
- Working harder than you expected
- Getting through the frustrations of being constantly rejected by customers
- Finding and hiring good employees
- Terminating poor-performing employees in a way that doesn’t result in legal liability
- Having to wear so many different hats
- Managing your time efficiently
- Maintaining some kind of work/life balance
- Knowing when to pivot your strategy
11. What are the biggest mistakes made by startup tech entrepreneurs?
- Not starting with enough capital
- Thinking that success will come quickly
- Not keeping an eye on the cash burn of the business
- Not focusing on the quality of the product or service
- Not getting sufficient customer feedback
- Underestimating the importance of sales and marketing
- Not adapting or iterating quickly enough
- Not understanding the competitive landscape
- Ignoring legal and contract matters
- Ignoring intellectual property issues
- Hiring the wrong employees
12. What should tech company founders do to develop a minimally viable product?
Many tech startups take too long to develop a minimally viable product (MVP), which refers to the most basic functional version of your product. The product has to be well designed and something that customers truly want. You need to conduct usability testing and get customer feedback, which will help guide you in refining and improving the product. Determine who your target market is, and tailor the product to that market. That is what is referred to as “product/market fit.” Be prepared to pivot if the MVP isn’t getting traction.
13. What financial metrics should tech founders focus on?
Even if a CEO or founder does not have a financial or accounting background, it is imperative that he or she constantly monitor and analyze the company’s key financial metrics. Failure to do so can have serious negative consequences for the business. Depending on the nature of the business, the following monthly key metrics will be important:
- Cash burn (or monthly positive cash flow)
- Gross revenues (and key components thereof)
- Gross expenses (and key components thereof)
- Gross margin (the difference between revenue and costs of good sold divided by revenue, expressed as a percentage)
- Lifetime value of a customer
- Customer acquisition cost
- EBITDA (earnings before interest, taxes, depreciation, and amortization)
- Customer churn
14. How can I protect my great tech idea?
Ideas are a dime a dozen. It’s the actual implementation of an idea that is more important. If it’s truly unique and patentable, get a patent for it (see www.uspto.gov). If the idea cannot be patented, you may get some protection through copyright, trade secret programs, or NDAs.
15. How can I obtain the domain name I want?
Every good “.com” domain name is already taken, and we usually only recommend that a business use a “.com” name for its website. Ultimately, 99% of domain names are available for purchase—you just have to be prepared to pay for the name you want. Do a “WHOIS Search” at www.networksolutions.com to find out the contact information for the owner of the domain name you are interested in, and offer to buy the name. Don’t be naive and offer $500 for a premium domain name. You will be ignored. Be willing to pay a fair amount for a good name. Be prepared to pay a lot for a common word domain name like “administer.com,” “recuperate.com,” or “resemble.com.”
16. I have an invention idea for a new tech product. How do I check that someone hasn’t already invented this idea?
Key steps to take:
- Do a Google search on the keywords associated with your invention.
- Do a search online of the U.S. Patent and Trademark Office at uspto.gov.
- If that works and you want to explore getting a patent on the idea, hire a patent lawyer.
17. Do I need a business plan?
Probably not. Our preference is to start with a 15-20 page PowerPoint deck presenting the business. For more information, see How to Create a Great Investor Pitch Deck for Startups Seeking Financing and Don’t Waste Time on a Startup Business Plan—Do These 5 Things Instead.
18. What marketing steps should I undertake for my tech startup?
To succeed in business, you need to be continually attracting, building, and sometimes even educating your target market. Make sure your marketing strategy includes the following:
- Learn the fundamentals of SEO (search engine optimization) so that people searching for your products and services online can find you near the top of search results.
- Use social media to promote your business (LinkedIn, Facebook, Twitter, Instagram, Pinterest, etc.).
- Engage in content marketing by writing guest articles for relevant websites.
- Issue press releases for any significant events.
- Network continually with others in your industry.
19. What do I have to worry about for my customer contracts?
Business contracts are legally binding written agreements between two or more parties. They are an important part of business and need to be created and/or negotiated carefully.
While smaller businesses will often conduct business based on informal handshake agreements or unspoken understandings, the more that is at stake, the more essential it is to have a signed contract. A contract serves as the rules that must be followed by both parties. It presents each party with the opportunity to:
- Describe all obligations they are expected to fulfill.
- Describe all obligations they expect the other party (or parties) to fulfill.
- Limit any liabilities.
- Set parameters, such as a time frame, in which the terms of the contract will be met.
- Establish payment and other terms.
- Clearly establish all of the risks and responsibilities of the parties.
A contract is, in essence, a written meeting of the minds. While it is typically drawn up by one party and favors the needs and requirements of that party, it should initially be thought of as a work in progress that changes and grows as each party contributes to it prior to signing, when it becomes binding on all parties. “Consideration,” whether it is monetary or a promise to do work or provide a service by a specified date, is at the root of a contract.
20. What should I know in seeking angel investors for my tech startup?
In reviewing a prospective investment, angel investors especially care about:
- The quality, passion, commitment, and experience of the founders
- The market opportunity being addressed and the potential for the company to grow to become very big
- Evidence of early business traction
- Interesting intellectual property or technology
- A reasonable valuation for the company
- The likelihood of the company being able to raise additional financing in the future if progress is made
Angel investors will want to initially see the following from a startup:
- A clearly articulated elevator pitch for the business
- An executive summary or investor pitch deck
- Possibly a prototype or working model of the company’s product or service
- Any early adopters, customers, or partners
There are a variety of ways to find angel investors, including:
The best way to find an angel investor is through a personal introduction from a colleague or friend of an angel. Using LinkedIn to ascertain mutual connections can be helpful.
21. What permits, licenses, or registrations do I need for my tech startup?
Depending on the nature of the business, you may need the following permits, licenses, or regulations:
- Permits need for regulated businesses (aviation, agriculture, alcohol, etc.)
- Sales tax license or permit
- City and county business permits or licenses
- Zoning permit
- Federal and State tax/employer IDs
22. What do I need to worry about when hiring an employee?
- Are you making sure the employee isn’t subject to a non-compete agreement from their previous company?
- Have you done a reference check?
- Does the employee have relevant experience for the job?
- Will the employee fit in with the company culture?
- Do you have a good form of employment “at will” letter for the employee to sign (allowing you to terminate the employee for any reason if it doesn’t work out)?
- Are you making sure the employee isn’t bringing over and using confidential information from a prior employer?
- Are you staying away from asking illegal questions in the job interview (such as how old are you, what is your religion, etc.)?
23. What agreement should I have with my startup co-founders?
If you start your company with co-founders, you should agree early on about the details of your business relationship. Not doing so can cause significant legal problems down the road (a good example of this is the infamous Zuckerberg/Winklevoss Facebook litigation). Think of the founder agreement as a form of “pre-nuptial agreement.” Here are the key deal terms your written founder agreement needs to address:
- How is the equity split among the founders?
- Is the equity ownership subject to vesting based on continued participation in the business?
- What are the roles and responsibilities of the founders?
- If one founder leaves, does the company or the other founder have the right to buy back that founder’s shares? If so, at what price?
- How much time commitment to the business is expected of each founder?
- What salaries (if any) are the founders entitled to? How can that be changed?
- Which founders will become members of the company’s board of directors? (the board will have important powers, including the power to terminate employees, including the CEO)
- Under what circumstances can a founder be removed as an employee of the business? (usually, this would be a Board of Directors decision)
- What assets or cash does each founder contribute or invest into the business?
- How will a sale of the business be decided?
- What is the overall goal and vision for the business?
24. What key legal issues should I be concerned about for my tech startup?
Ignoring key legal issues can sink a startup. CEOs and founders should ensure that the company is taking steps to comply with all applicable laws. Here are a number of the key legal points startup tech companies should focus on:
- Has the company been properly organized?
- Has the company complied with all applicable securities laws when issuing stock or options?
- Are appropriate steps being taken to protect the company’s intellectual property (such as through trademarks, copyrights, patents, non-disclosure agreements, etc.)?
- Is each employee and contractor required to sign a comprehensive Confidentiality and Invention Assignment Agreement (ensuring that any intellectual property developed by the employee or contractor that is related to the business of the company is deemed owned by the company)?
- Is the deal with any co-founders clearly documented, and in the event of a departure is it clear that there won’t be a dispute about the company’s equity ownership?
- Does the company have a good form of customer contract, protecting the company and mitigating liability exposure?
- Has the company obtained all the required documentation from employees (e.g., “at will” employment letters, benefit forms, IRS Form W-4, USCIS Form I-9, etc.)?
- If the company has issued stock subject to vesting, have the stockholders filed 83(b) elections with the IRS?
Copyright © by Richard D. Harroch. All Rights Reserved.
About the Authors
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on Internet, digital media, and software companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of a 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He was also a corporate and M&A partner at the Orrick law firm, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 250 M&A transactions and 250 startup financings. He can be reached through LinkedIn.
Mike Sullivan is a partner and head of the Corporate Group in the San Francisco office of Orrick, Herrington & Sutcliffe. He focuses on representing emerging companies, entrepreneurs and angels/venture capital funds. Mike has led hundreds of financings and M&A transactions for emerging companies in a wide variety of industries, particularly in the software, satellite/space, mobile, digital media, cleantech and food/wine/spirits sectors. Mike is a contributor to Venture Capital and Public Offering Negotiation (Aspen Law & Business). He can be reached through the www.orrick.com Website.