- The video discusses the legal and accounting mechanics that startups need to consider in the beginning stages
- It emphasizes the importance of forming a separate legal entity, preferably a Delaware corporation, to protect personal liability
- The video recommends using services like Clerky to help with the incorporation process
- It stresses the importance of keeping all signed documents in a safe and organized place for future reference and due diligence
- The video also touches on equity allocation and advises against disproportionate stock distribution based on the idea or founder's role
- It highlights the importance of teamwork and execution in creating value for the company.

- Founders need to trust each other and be honest about their expectations for the startup
- Disproportionate ownership can cause founders to be out of sync with each other
- In top YC companies, there are no instances of significantly disproportionate equity splits
- Founders need to sign paperwork and stock purchase agreements to own their shares
- Filing an 83B election is crucial for individual and company taxes
- Vesting is important to prevent founders from leaving with a large chunk of equity
- Vesting aligns incentives and shows commitment to the company
- Investors don't want founders to have a big equity ownership stake if they can quit whenever they want
- There are two ways to raise money: with a set price (series A/B) or without a set price (seed round)
- Convertible notes or safes are used for raising money without a set price
- Investors who use convertible notes or safes do not have voting rights until the price is set in a priced round

- Valuation cap is set for early investors in a company, determining the conversion into shares and future share prices.
- Future dilution should be considered when raising money, as early investors may own a significant portion of the company.
- Investors should be sophisticated and understand the risks associated with investing in startups.
- Founders should be aware of common investor requests, such as board seats, advisor roles, pro rata rights, and information rights.
- Founders should understand the impact of these requests on their company in the long run.
- Business expenses are important for tax purposes and should be deducted on the company's tax return.

- Non-business expenses incurred by a company are not tax deductible and can increase the profits that the company has to pay tax on.
- It is important for companies to have separate bank accounts for business expenses and not use company funds for personal expenses.
- Founders should use investor money to make the company successful and not spend it as they please.
- Keeping receipts and documents is crucial for bookkeeping and accounting purposes.
- Founders should pay themselves and their payroll taxes to avoid legal issues.
- Founder breakups can become messy if founders haven't paid themselves, as unpaid wages can be used as leverage.
- Hiring employees involves understanding the differences between employees and contractors and complying with employment laws.
- Employees must be paid at least minimum wage and companies need workers' compensation insurance.
- Using a payroll service provider can help with payroll management and ensure compliance with legal requirements.

- Using a payroll service provider can help avoid complications and mistakes in managing employee payroll.
- Firing employees can be difficult, but it is important for the growth and success of a company.
- Best practices for firing someone include doing it quickly, communicating effectively, paying all wages and accrued vacation immediately, cutting off access to digital systems, and repurchasing any invested shares.
- Other important aspects of running a company include keeping it simple, organizing paperwork and finances, understanding equity ownership and financing documents, ensuring employees and founders are paid, and assigning intellectual property to the company.
- Finding a good accountant or CPA for a startup can be done through recommendations and using services that specialize in working with startups.
- The cost of incorporating and hiring legal counsel will depend on the complexity of the business and the fundraising process.
- Working with cryptocurrencies and crypto equities can present challenges, particularly with banks and their unfamiliarity with these types of transactions.

The video discusses the legal and accounting considerations for startups, including the importance of forming a separate legal entity, using services like Clerky for incorporation, and keeping signed documents organized. It also emphasizes the importance of fair equity allocation, signing necessary paperwork, and filing an 83B election. The video explains the different ways to raise money and the importance of considering future dilution. It also highlights the need for founders to understand investor requests and manage business expenses properly. Additionally, it covers topics such as hiring employees, firing employees, and the importance of organizing paperwork and finances. Lastly, it mentions the challenges of working with cryptocurrencies and crypto equities.

Lecture Transcript: http://genius.com/Kirsty-nathoo-lecture-18-mechanics-legal-finance-hr-etc-annotated

There's a lot that goes behind the scenes in running a startup. Getting the legal, finance (equity allocation, vesting), accounting, and other overhead right will save you a lot of pain in the long run. Kirsty Nathoo, CFO at Y Combinator, and Carolynn Levy, General Counsel at Y Combinator, cover these very important topics in this lecture.

See the slides and readings at http://startupclass.samaltman.com/courses/lec18

Discuss this lecture: http://startupclass.co/courses/how-to-start-a-startup/lectures/64047

General Counsel, Kirstie and Carolyn, and they're going to talk about finance and legal mechanics for startups.

This is certainly not the most exciting of the classes, sorry.

But if you get this right, this is probably the class that you'll be excited about the most.

So thank you very much for coming and yeah.

So like Sam said, this lecture's about the mechanics of startup.

And Kirsten and I are going to be talking about some of the basic legal and accounting issues that your startup may face in the very beginning.

I was watching Paul Graham's video and at 1 point he says, founders don't need to know the mechanics of starting a startup.

I thought, oh no, that's exactly what Sam titled this lecture.

But what PG actually says is that founders don't need to know the mechanics in detail.

Because it's very dangerous for founders to get bogged down in the details.

And Kirstie and I can't give you the details in 45 minutes anyway.

So, our goal here today is to Make sure that you do know better than to form your startup as a Florida LLC.

So, as Sam mentioned, we were also worrying that it's going to be pretty boring for, for you to listen to an accountant and a, and a lawyer talking about this.

You know, you've had some really amazing founders talking about really interesting things.

But, but like Sam said, you know, this, this is the kind of stuff that if you know the basics, you can get yourself set up in the right way, avoid pain, stop worrying about it, and then concentrate on what you actually want to do, which is make your company a success.

And so, you know, we refer to this term startup all the time.

And probably in the back of your head, you kind of know that by startup we mean there has to be some legal entity, and that's, you know, some kind of separate legal entity.

We'll talk a little bit more about how we actually set that up and what that means to you.

And you also probably know that a startup will have assets, IP, inventions, other things, and that the company needs to protect those.

So we'll talk a little bit more about that, about how to raise money, hiring employees, and entering into contracts.

So there's a few other things that you need to talk about whilst you're Setting up your company, which kind of ferrets out a few issues amongst founders.

Things like, who's going to be in charge, and how much equity is everybody going to own?

So those are really good things to talk about too.

I have like the geriatric glasses, which is actually pretty fair.

Okay, so the first thing we're going to talk about is formation.

Your startup is going to be a separate legal entity.

And then, and you guys probably already know this, but the primary purpose for forming a separate legal entity is to protect yourselves from personal liability.

And what that means is, if your company ever gets sued you know, it can't, it's not your money in your bank account that the, that the person can take.

So then the question is, where do you form 1?

But the easiest place is Delaware, and I'm sure you're all familiar with that as well.

But Delaware is in the business of forming corporations.

The law there is very clear and very settled.

The other thing is that investors are very comfortable with Delaware.

They already invest in companies that are Delaware corporations.

Most of their investments are probably Delaware corporations.

So if you are also a Delaware corporation, then everything just becomes much more simple, right?

There's less diligence for the investor to do.

You don't have to have a conversation about whether or not to reincorporate your Washington company into Delaware.

So, there's a reason that so many companies do it.

We had a company at YC about 2 years ago that was originally formed as an LLC in a state that I'll, I'll say Connecticut.

The founders had some lawyer friends there who said this is the right way to do it.

And when they came to YC, we said you guys need to convert to Delaware.

So the lawyers in Connecticut did the conversion paperwork and unfortunately they didn't do it right.

They made a very simple mistake, but it was a very crucial mistake.

The company was recently raising money, Like a lot, a lot of money, and this mistake was uncovered.

That, that basically the mistake was this company thought it was a Delaware corporation for a couple years, but in fact it was still a Connecticut LLC.

And I'll just say this, 4 different law firms were needed to figure that 1 out, 2 in Delaware, 1 in Connecticut, 1 here in the Silicon Valley.

And the bill right now is at $500,000 for a conversion mistake.

Keep it really simple and familiar for yourself.

The reason we incorporate all companies the same way at Y Combinator is because it's easy.

So don't get fancy, just save yourself some time and money.

Okay, so once you've decided that you're going to be a Delaware corporation, how do you actually set that up?

And it requires a few different steps, but the first 1 is actually really easy.

You literally just fax 2 pieces of paper into Delaware saying, we're going to set up a corporation.

All that does though is create a shell of a company.

It doesn't actually do anything within the company.

So after that, you then need to complete a set of documents that, among other things, approve the bylaws of the company.

Delaware requires that somebody has the title of CEO, President, and of secretary.

So also at this point, you need to complete documents that assign any inventions or any code or anything that you as an individual create.

And remember At this point, it's a really good thing to think about.

You as founders have to think about things in 2 different ways.

You always have to be thinking, am I doing this as an individual, as me, or am I doing this on behalf of the company, which is a separate entity?

So you have to maintain that split in your mind going through all of this.

And we'll talk more about where that comes in a little bit later.

So there are services that can help you get incorporated.

But there are also other online services that help.

And the 1 that we often use with a lot of the YC companies is called Clerky.

And they are set up so that all the standard, basic documents are used.

And They get you set up in a very vanilla way so that you can just move on and keep, keep focusing on what you need to do.

These are really important documents that are going to be setting what the company does and what the company is.

So it's really, really important that you actually keep these signed documents in a safe place.

And it sounds so basic, but we get so many founders coming to us saying, I don't know.

And they have no idea what they are or where they are.

So really, really make sure that you keep them in a safe place.

And let's be, let's be honest, this is not the glamorous part of running a startup, you know, filing documents.

But actually at the times where this is crucial are going to be at really high stress times in the startup's life.

It's likely to be if the company's raising a big series A round or if the company's being acquired.

The company will have to go through due diligence And there will be lawyers asking for all this stuff.

And if you don't have it and you don't know where it is, it's just making a really stressful situation even more stressful.

So really the, you know, the key thing here is, like we say, keep it simple, but keep those documents in a safe place and keep it organized.

Okay, so now we're going to talk about equity and we're going to touch on a couple different things in this section.

The first thing that we're going to talk about is equity allocation.

I'm talking about if your company's stock is a pie, you're talking about how to divide the pie.

And you're talking about this with your co-founders.

Well, if you're a solo founder, this really isn't important.

But if you are a team of 2 or more, then this issue is absolutely critical.

So the first thing that you need to know is that execution has greater value than the idea.

A lot of founder teams give way too much credit and therefore a lot of the company's equity to the person who came up with the idea for the company.

And ideas are obviously very important, but they have 0 value.

Who's ever heard of a billion dollar payment for just an idea?

So value is really created when the whole founder team works together to execute on an idea.

And so you need to resist the urge to give a disproportionate amount of stock to the founder who is credited with coming up with the idea for the company.

The next thing you want to think about is, okay, so how much stock, or should the stock be allocated equally among the founders, and from our perspective, the simple answer is probably yes.

Our mantra at Y Combinator is that stock allocation doesn't have to be exactly equal, but if it's very disproportionate, that's a huge red flag for us.

We wonder what conversation is not happening in, among the founder team when the ownership isn't equal?

For example, is 1 founder secretly thinking that this whole startup thing is temporary?

Is 1 founder over-inflating the work that he or she has already done on the company, or over-inflating his or her education or prior experience?

Do the founders really trust each other and have they been honest with each other about their expectations for this startup and for the future?

So when ownership is disproportionate, what we worry about is that the founders are not in sync with 1 another.

Thirdly, it's really important to look forward in the startup, not backwards.

And said another way, all, all the founders in it 100%, are they all in it for the long haul?

If the expectation at your startup is that each founder is in it 100%, and you're all in it for the long haul, then everything that happened before the formation of the company shouldn't matter.

It doesn't matter who thought of the idea.

It doesn't matter who did the coding or who built the prototype or which 1 has an MBA.

It will feel better to the whole team if the allocation is equal, because the whole team is necessary for execution.

In the top YC companies, which we call those, you know, with the highest valuations, There are 0 instances where the founders have had significantly disproportionate equity split.

All right, so you've had the conversation about how to split the equity, but then what?

Again, we talked to many founders who are actually surprised that they have to do something in order to own this stock.

They think about, they think that talking about it is, is actually enough.

And this again, it's another situation where you have to think about you as an individual versus you as a representative of the company.

And if you, if you equate this to a large company, you know, if you, if you worked at Google and you were told as part of your compensation package that you would be receiving some shares.

You would expect to sign something to get those shares.

And if you didn't, you'd be thinking, oh, what's going on here?

Well, it's the same thing with, with a small company as well.

So in this case, the paper, the, the documents that you're signing is a stock purchase agreement.

So you as an individual buy the shares from the company.

And in any situation, if you're buying something, there's a 2 way transaction where you pay for something and you get something in return.

And in this case, you're getting shares in return for either a cash payment Or for contributing IP or inventions or code to the company so that the company actually owns everything that you've done in the past.

So we also refer to that stock being restricted because it vests over time.

And we're going to cover that next in more detail.

But as a result of the stock being restricted and vesting, there's 1 very, very crucial piece of paper.

That we talk about until we're blue in the face to everybody, because there's actually no way to go back and fix this.

And this is actually 1 of the things that, because there's no, there's no way to fix this, this has blown up deals in the past.

We've, we've seen companies where, because they haven't filed what's called an 83B election deals have blown up.

And I'm not going to go into detail about what that 83B election is actually about, but just leave it as it affects your individual taxes and it affects the company's taxes.

So, you know, here we have the main, the main things here are sign the paperwork, sign the IRS, sign the stock purchase agreements, sign the 83B election, and make sure that you actually have proof that you've sent that in.

Because if you don't have the proof, it just goes into a black hole at the IRS.

And investors and acquirers will walk away from a deal if you can't prove that.

So the next thing we're going to talk about is vesting.

And I imagine that many of you are familiar with what vesting is, but just in case, really simply, vesting means that you get full ownership of your stock over a specific period of time.

So we're talking about the stock that Kirstie just said, You bought your stock of your company, and you own it, and you get to vote it.

But if you leave before this vesting period is over, then the company can get some of those unvested shares back.

So and I'm just gonna, just so you guys know, the other ways to refer to vesting, you'll hear restricted stock.

That means that, that stock that's subject

The IRS speak for this as shares that are subject to forfeiture.

Okay, so what should a typical vesting period be?

In Silicon Valley, the so-called standard vesting period is 4 years with a 1 year cliff.

This means that after 1 year, the founder vests in, or fully owns, 25% of the shares.

Then the remaining shares vest monthly over the next 3 years.

Founder buys stock on Christmas day, let's say, and then quits the company on the following Thanksgiving.

In that case, the founder leaves with 0 shares, right?

If the founder though quits the day after the next Christmas, so a year and a day later, he or she is vested in exactly 25% of the shares, right?

In that case, the 1 year cliff has been met.

So, what happens to the shares when a co, when a founder stops working at the company?

In the example I just gave where the founder quit a year and a day after purchasing the shares, 75% of those shares are still invested.

And the company will repurchase all, that full 75% of those shares from the founder.

So it's the same price per share that the founder paid.

And it's really just giving the founder his or her money back.

So then the question is, why would you have vesting?

Why would founders do this to themselves, right?

Cuz it's just the founders, they're, they're doing this on their own shares.

So, and probably the number 1 reason why vesting is important has to do with founders leaving the company.

So without, so let's say if you didn't have vesting and a founder leaves, a huge chunk of the equity ownership leads with her, him, with him or her.

And obviously, that is not fair to the founders left behind.

And we're actually going to talk about this a little bit more when we get to the founder employment slide.

But the other reason to have vesting is the concept of skin in the game.

The idea that founders need to be incentivized to keep working on their startup.

If a founder can walk away with his or her full ownership at any point in time, then why would you stay and grind away?

And the reason is because the skin in the game concept applies to solo founders as well.

And investors really want to see all founders, even solo founders, incentivized to stay at the company for a long time.

And the other reason that single founders should put vesting on their shares is to set an example for employees, because you can imagine it would be, you know, inappropriate for a founder to tell an employee that he or she has to have 4 year vesting on his or her shares, but the founder doesn't think that he or she needs any on their own shares.

A founder who has vesting on his or her shares then sets the, sets the tone for the company saying, We're all in it for the long haul.

I would say, vesting aligns incentives among the founders, if they all have to stick it out and grow the company before any of them get any of that company.

And then number 2, investors don't want to put money in a company where the founders can quit whenever they feel like it and still have a big equity ownership stake in that company.

Okay, so moving on, we've now got a beautifully formed corporation in Delaware, everybody's got their stock.

It's all the, the plain vanilla standard paperwork.

You know, probably the next stage of a company's life is needing to raise some money.

So we're going to, we're going to talk a bit more about that.

And, you know, we know that you've already heard a lot from investors and from founders already in, in this set of classes.

And they've been talking much more around the tactics and how to raise money, but what about the paperwork?

What about when somebody actually agrees to invest?

So, first of all, in terms of logistics, in very simple terms, there are 2 ways to raise money.

So, either the price is set for what the, the money that comes in, or the price isn't set.

And by price, we mean the valuation of the company.

So rounds can actually be called anything.

People can, can name them whatever they want.

But generally, if you hear the term seed round, it would mean that the price has not been set.

And anything that's a series A or a series B would be something where the price has been set.

So not setting the price is the more straightforward, fast route to getting money.

And usually the way that this is done is through convertible notes or safes.

And again, this is a two-way transaction.

So there's a piece of paper that says, for example, that an investor is paying $100,000 now, And in return has the right to receive stock at a future date when the price is set by investors in a priced round.

So it's important to note that at the time the paperwork is set, that investor is not a shareholder.

And therefore doesn't have any voting rights on the company.

They will have some other rights which Carolyn is going to talk about separately.

Of course, investors want something in return for putting in money at the earliest, i.e.

is where the concept of a valuation cap comes in, which I'm sure many of you have heard mentioned before.

So usually the documents for an un, un-priced round set a cap for the conversion into shares.

And that's not the current valuation of the company.

It's actually an upper bound on the valuation used in future to use, used in future to calculate how many shares that investor's going to get.

So for an example, an investor that invests $100,000 on a safe with a $5 million cap, then a year later, the company raises a priced round with a valuation of let's say $20 million.

Then the early investor would have a much, much lower price per share, about a quarter.

And therefore their $100,000 would buy them approximately 4 times more shares than an investor that was coming in and putting in 100,000 in that series A price round.

So that's where they get their, their reward for being in early.

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Legal and Accounting Basics for Startups with Kirsty Nathoo and Carolynn Levy (HtSaS 2014: 18)