Startup founders are faced with the difficult task of having to make critical business decisions on a daily basis. Working with thousands of companies and founders over the years, the Gust Launch team has witnessed many situations in which having better information from the start could have prevented poor decision making and painful lessons. Gust Launch arms founders with the proper tools and information so that they can take a proactive approach to building their startups. Here is a non-exhaustive list of early mistakes that founders should be aware of so that they can avoid them and have a better chance of future success.
1. Forgetting to file an § 83(b) election.
Most early stock grants that founders issue are subject to vesting. Vesting (as it applies to stock, not options) is the company’s diminishing right to repurchase stock should the stockholder leave the company during a set period of time. Vesting is an important mechanism in aligning incentives with early stockholders so that they will continue contributing their time and efforts to the company over the long term.
Under normal tax treatment, stock that is subject to vesting will have income recognition events each time part of the stock grant vests. This is due to the stock grant not being considered fully in the possession of the stockholder because there is still “a substantial right of forfeiture” (it can be automatically repurchased). Over a normal vesting period, this means there could be considerable tax recognition as the value of the common stock grows (sometimes rapidly) over time.
Section 83(b) provides an opportunity for shareholders with unvested stock to make an election that will accelerate the income tax recognition on the entire stock grant rather than as it incrementally vests. Companies can potentially save a lot of money on taxes through an 83(b) election. The stockholder won’t owe any taxes at the time of their grant as it vests if they issue their initial stock grants at par value for par value.
The stockholder (not the issuing company) has to make an 83(b) election to the IRS within 30 days of the “date of transfer” (typically the grant date). Once that deadline has passed, the election can no longer be made. This is a potentially huge tax savings opportunity that founders can miss within the first month of their new corporation’s existence.
2. Not paying taxes
More on taxes. The two primary types of taxes every Delaware corporation has to pay are corporate income taxes and Delaware franchise taxes. Corporate income taxes are assessed at the state and federal levels, with a tax return due April 15 every year. Depending on its operational and financial circumstances, a company may also be subject to several other types of taxes (quarterly tax returns, sales taxes, and payroll taxes). Not filing and paying corporate taxes can result in a number of different late penalties. One small, temporary “escape hatch” is that a company can always file an extension on their return and extend their deadline to October 15. If the company believes they may owe taxes, the company may have to make an estimated tax payment.
Delaware Franchise Taxes are due by March 1 each year and need to be paid in order to maintain good standing in Delaware and retain all the protections of a corporation. Franchise taxes are assessed based upon either the assumed par value method or the authorized share method. Almost all Gust Launch customers utilize the assumed par value method and pay ~$450 per year in franchise taxes. Not paying franchise taxes by the deadline results in $200 late fees with 1.5% monthly interest and potentially voiding the corporation in Delaware if the taxes are not paid for two years.
3. Issuing too many authorized common shares to the founding team
At incorporation, all Delaware Corporations have a maximum amount of shares they can grant without amending their Certificate of Incorporation. Most high growth startups (including companies incorporated on Gust Launch) will start out with 10M authorized shares. It is important to note that authorized shares do not signify who currently owns the company—issued and outstanding stock is what determines company ownership. If a company issues all of its authorized shares, it has to amend its Certificate of Incorporation to issue more common stock. The amendment process requires a shareholder vote and an additional filing fee. This sort of time consuming and unnecessary work can usually be avoided with a bit of pre-planning and issuing the correct number of shares from the beginning.
4. Granting fully vested stock to a cofounder
As mentioned in #1 in this list, most startups will issue founder stock that is subject to vesting. This mechanism is in place to align incentives, since the primary reason for a cofounder receiving stock is to substantially contribute to the startup over a long period of time. If a founder walks away from the company before the stock has fully vested, he or she will only retain his or her vested shares, with all of the unvested shares being repurchased by the company at the price the shares were granted at.
Having a vesting schedule in place helps protect against a scenario where a cofounder starts out with the company, is issued a substantial fully-vested stock grant, and leaves the company shortly thereafter. Without an automatic repurchase mechanism in place to repurchase shares, the company has a shareholder on their cap table with significant equity, whose total contributions to the company do not match their level of ownership. The only way for the company to get those shares back is to negotiate with the former founder to repurchase them. Repurchase negotiations can be extremely expensive and an unnecessary distraction for an early-stage company.
5. Not complying with securities laws
Securities compliance is the statutes, regulations, and practices that govern taking money from investors. Securities are managed at both the state and federal level, with various exemptions and exclusions in place to avoid the cumbersome and expensive process of registering with the SEC and state regulators. The most common of these exemptions is to only issue to “accredited investors” under Rule 506. What makes a person accredited is subject to very specific requirements. It is possible to issue securities to unaccredited investors, however, the additional hurdles and required disclosures could end up costing a company more money in legal fees than the value of the investment itself.
The consequences of not complying with securities regulations are harsh. Penalties can include an automatic right for the investors to demand their money back, state and federal penalties and criminal investigations, and the officers and directors of the company being personally financially liable to repay the investors. Whenever a startup is considering taking money from a potential investor, it should work with an attorney to make sure it is properly complying with securities regulations.
6. Leaving due diligence prep until the last minute
If angel investors or venture capitalists are seriously considering investing in a startup, they will ask for extensive and detailed information about the company. The investors (along with their lawyers) will carefully comb through all of the materials to verify the claims the company has made up to that point. Due diligence typically happens right before closing an investment.
Investors take the due diligence process very seriously and expect all the materials to be accurate and thorough. Not being able to produce materials when requested stalls the process and can frustrate potential investors. Startups should take the time before starting due diligence to prepare their documents, in order to help speed things up and increase their company’s chances of closing an investment.
7. Investing too little or too much money in your own company
Investors want to see that founders have financially invested in their companies. This demonstrates to investors that the founders are committed and believe in their product. There is no magic number for how much to invest; the amount primarily depends upon a founder’s personal financial situation.
However, carrying too much personal debt can also cause problems with investors. Having a founder that is overly leveraged sends a signal to investors that the founder could be put into a situation where they might seek a premature liquidity event in order to cover their personal debts.
Before you max out your credit cards and commit to a founder’s salary, make sure you are considering what personal debt you can realistically carry for the first few years of your startup.
8. Seeking investment before the company is ready
It is extremely rare (almost statistically impossible) for a company to obtain angel and venture capital investment on an idea alone. Investors require a company to have met some basic product milestones and metrics before considering investment. Additionally, the company needs to have some basic materials prepared, like a business plan and a pitch deck.
By not understanding what types of companies certain investors typically invest in, a company that is seeking investment too early is not putting its best foot forward. Further, many angel groups require applications that take time and effort to prepare from the company. Submitting an incomplete application or not having materials prepared is a quick way to be overlooked or rejected by investors.
Take the time to research your investors and prepare all required materials to the best of your ability.
Founders: don’t get caught up in the moment while pitching your company or answering tough investor questions. The easiest way to sink an opportunity is to be caught lying or misleading investors. A primary factor that most early-stage investors look at is the leadership team. Investors want to work with companies whose founders and officers act with integrity so that they can build a trusting relationship.
10. Being a jerk
Finally, don’t be a jerk. You only have one chance to make a good first impression; don’t waste an opportunity by being rude or unprofessional. Investors primarily invest in their local geographies, and the social and professional circles for early-stage investment are smaller than you think. Earning a reputation for being someone challenging to work with can be hard to overcome. Investors will check your references and people you have worked with in the past. Do yourself a service by treating everyone in a professional and respectful way.
Let Gust Launch help you avoid common mistakes so you can build your startup the right way.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.