A number of years ago I worked in product for Gust Launch. As a disclaimer, I am a staunch believe in the mission of Gust Launch and—more generally—decreasing the barriers to entrepreneurialism and innovation.
One of the things we did during my time at Gust Launch was form the Startup Legal Counsel network that is now included in the Accelerate and Raise plans. The idea is to connect founders with well-versed experts in the startup legal realm. I was not directly involved in the forming of that network; a team of startup lawyers were. I was more focused on building the internals of the platform itself, spending most of my time digesting legal topics and working with the team to streamline legal processes. Gust Launch has an extremely carefully crafted experience for walking startups through complex legal workflows in a very intuitive manner, but it is not a full replacement for a lawyer in all situations. Sometimes you need advice or representation that are outside the realm of Gust Launch.
What I failed to realize at the time was how important it is to have the right startup lawyer and how large of an issue the Startup Legal Counsel network of Gust Launch actually addresses. I will try to explain what I mean by this here.
First, let me say that the startup legal landscape is very broad and it is complex to those that are unfamiliar with it—even highly competent legal professionals that focus on other areas of law. Compounding that complexity is the fact that the legal landscape is directly tied to other specialties, including but not limited to accounting and finance. A very easy representation of this is entity formation. If Gust Launch didn’t handle the (easy) decision for startups to be a C-Corp incorporated in Delaware, I would dare say it would be commonplace to be misled by a lawyer or accountant in terms of how you should form your company. LLC? C-Corp? S-Corp? B-Corp? Someone new to the world of entity formation might not even realize that S-Corp and B-Corp aren’t even really entity types. One is a tax designation, the other a certification. You can be an LLC taxed as an S-Corp, or a C-Corp taxed as an S-Corp. A lawyer or accountant that does not fully understand the complexities of the startup world could easily lead you down the wrong path of how to set up your company, and the correct answer is not even a tough decision if you understand the nature of the startup world.
To be clear, outside of Gust Launch, startups often form as LLCs either because they didn’t hire a lawyer or because they hired the wrong lawyer. And they later pay to reconstruct themselves as a C-Corp once they realize they made a mistake. It happens all the time.
After leaving Gust Launch, I started Flatirons Development and the Flatirons Fund, where we strive to help startups build software products that achieve meaningful metrics in order to assist them in reaching their next milestone (often, fundraising). Flatirons Development has rather straightforward legal needs. Flatirons Fund is not quite as simple. The only reason I was able to understand when I was and was not talking to someone that knew what they were doing was because of the hours I spent with extremely intelligent startup counsel while building the Gust Launch product. It was a very frustrating experience finding someone reliable. I worked with general counsel. I worked with lawyers that specialize in startups. I worked with lawyers that specialize in venture funds. Time and again I could spot obvious issues in legal documents. The lawyers would even acknowledge them when I pointed them out. Some of these mistakes were not something you could ever spot without having immersed yourself in the startup legal field for quite some time.
I am not a lawyer but I am privileged to have been able to notice some of these issues. At Flatirons Fund, we have dealt with many first-time founders and more often than is comfortable, I find myself explaining to founders that they are dealing with poor legal counsel for their startup. In many cases, these conversations center around LLCs or standard early-stage securities.
With the approval of certain teams, let me illustrate a few examples that come to mind and briefly discuss the issues with them:
We worked with one team whose legal counsel was befuddled that Flatirons Fund was offering a loan to a startup that they could just “pay back later.”
Full stop. What was happening was that the lawyer was reading a Convertible Note and learning what a Convertible Note was as they did so. When the founding team came back to us to actually discuss why we would do this (as instructed by their lawyer), I felt flabbergasted. We are talking table stakes. The conversation gave pause as to whether Flatirons Fund should actually take on the investment because we started to question if the founders themselves knew what they were getting into with creating a startup, which is a long and intense journey.
With regards to “paying it back later,” startups are not typically profitable businesses. They use their money to fuel their high growth needs for long periods of time. It takes large amounts of capital to fulfill their visions. It is much more likely for convertible instruments to convert into equity than for a startup to be focused on paying them back.
We worked with one team that was gearing up to raise funds. They had amazing growth numbers, and a great pitch deck. Their lawyer was urging them to switch from a C-Corp to an LLC to “simplify their business structure and taxes.”
This situation was a shock to me frankly. LLCs are pass-through entities, which means that if your startup is profitable an investor could actually pay taxes on the profits of the startup. Investors don’t receive any income from startups and their investments are illiquid for long periods of time. They don’t want to pay personal taxes on your LLC’s profits when they receive no money from that LLC. This is just one issue with LLCs but the LLC/C-Corp conversation is covered many times over in Gust Launch content so I won’t expand further into this. Investors don’t want to invest in LLCs.
Again, the additional issue here is how you are perceived as a founder. If you walk into a room explaining you’re a C-Corp transitioning to an LLC and simultaneously raising funds, I wouldn’t expect to leave with a check. You sound silly.
We worked with one team that had formed as a C-Corp, taken in one investment, had plans to take on additional investment, and their legal counsel was encouraging them to switch from a C-Corp to an LLC.
I just expanded on one reason why investors don’t want to invest in an LLC. This particular situation is a bit different though because the startup had a single investor who was not a professional investor in private companies. Because of this, the investor could be completely fine with the situation and sign legal agreements helping convert their shares to units in an LLC. What they might not know is that they basically just took on unlimited personal financial risk. To me, this is the equivalent of putting 100% of your assets into shorting a stock -- the risk is uncapped and you could lose all of your personal assets if the company decides to remain an LLC and becomes very profitable because you keep paying taxes on those profits without receiving any income.
Most of the examples above focus on the omnipresent LLC/C-Corp issue in the startup world. However, I have seen equally as many errors in convertible instruments (Convertible Notes, SAFEs, KISS documents, etc). In fact, issues with distributing equity or a blunder on an important term in a security can be absolutely devastating to a company.
Getting the right legal counsel is hard, even if they claim to specialize in startups or are referred by someone else. The situations above were perpetuated by smart lawyers and law firms. Don’t undervalue the fact that Gust Launch has done the work of building a network of well-informed lawyers on your behalf.
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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.