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The Barcode Podcast is presented by Titanium CPG Insurance. Titanium protects forward-thinking consumer brands with a range of commercial insurance products and risk management services designed specifically for natural and organic food and beverage companies. Learn more at titaniumcpg.com

Welcome to The Barcode Podcast, where we equip emerging consumer brands. I’m your host, Ben Ponder, and at Barcode, we’re here to give our listeners the knowledge and tools you need to thrive in the marketplace.

For today’s episode, we’re sharing a live recording from one of our past Barcode events. The CPG founders here in Austin – like so many of you listening – are often looking for investors in their companies so they have the money they need to continue making their products. While bringing on investors can be a great move for continued growth, it could also be, in some cases or situations, a catastrophically bad move. To decide what’s right for you, you first have to understand how equity works and also what your reasons and expectations are with regard to taking on outside investment. At Barcode, our focus is on equipping you for your entrepreneurial journey, and this episode is full of information that will get you on the path to make the right decision for your company and situation. We also have a PDF handout that accompanies this episode

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BEN                 I find that this topic around equity is of a lot of interest to people and the general base knowledge is elusive.

Big disclaimer at the beginning, I am neither a lawyer nor an accountant. Please do not construe this as either legal or accounting advice, consult your personal professional. However I do, I’m an entrepreneur and a curious person and I find that it is a lot of this, this information can be difficult to process and I think it’s sometimes helpful to have an introduction to it from someone who maybe isn’t versed in, in all of these things from a professional and lifelong career perspective.

So I’m presenting this tonight not as the definitive account of everything one would need to know about startup equity. Hopefully, there is enough information here that allows you to go deeper and to consult other people in your life who knows some stuff. So that’s, that’s the spirit with which we’re sharing this tonight. So, uh, a- as I was thinking about how to even approach, you know, it’s kind of like a, like there, you’re up in an airplane and you’re trying to, to land the plane. There are so many angles, so many, so many vectors that you could, you could come at this, this topic of startup equity. And so we’re not going to cover all of them, we can’t, uh, the time doesn’t allow it. This is a very esoteric field and highly specific and technical.

And so we’re going to avoid a lot of that stuff, but a- as you may have heard, there’s a, there’s a thing called Wall Street and Wall Street, they get very specific about this kind of stuff. We’re not going to get into the details that you might get into if you’re an investment banker. But my hope is that you are equipped because that’s what we’re about here at Barcode – equipping startups – and that you are equipped with at least a, a vocabulary and a framework, a way of thinking about these things.

So I’m going to share some information that hopefully is, is a helpful framework or guide for you and then we’ll have plenty of time hopefully to for- for your questions because ultimately we can share all the theory that, that we want to. And then you’re like, “Yeah, yeah, yeah, but how do I do this?

So with that, with that preface, I want to talk a couple of, uh, comments broadly about equity. And equity by the way, we’re talking about ownership and, uh, and equity is, is a- a form of ownership if you are a sole proprietor, that means you own a business by yourself, then you own all the equity. And that’s, that’s the good, bad and indifferent of your business, right? So you may have, have shares of stock, you may have units of something else but you own the whole pie.

But in most cases, and in most businesses, as you grow, it is rare that one person owns the whole pie and it can get a little bit complex. So we’re going to talk about the different people who might own a piece of the pie and what kinds of pieces of the pie they possibly own or could own or should own. And, and again, there’s a lot to this because you’re like, “Yeah, I just like the middle part of the pie. I don’t really like the crust.” And so there’s probably some ways we could, we could extend that metaphor in a few different ways. But the- the key thing here is that, uh, I’m a big believer in aligned incentives and in one reason why equity is ever in the equation is because what you’re trying to do is to have other people in the business think like and act like owners.

And equity is one way that you can do that because owners, and I think we all know this from either having owned or run our own business or even a project but owners act differently than hired hands, right? If you own the thing, it’s you’re, you’re fully accountable for the thing. And so you’re the last one to, to, to leave, you’re the first one there in the morning. You, you have to lock the door, you have to pay the electricity bill and that sort of thing.

So that’s what, when you start thinking about equity and sharing equity with other people, you’re trying to get their incentives aligned with your incentives. And in this case, as a startup founder or co-founder. We’ll talk a little bit about raising money, certainly equity comes into play more often than not because somebody is raising money and, and raising capital. Fundraising has different, different, uh, different terminology around it.

But I- I did want to throw out one quick thing, which is my, my strong encouragement to everybody here is because there are a lot of people who watch Shark Tank or they, they hear about some things here and there and they think, “Oh, this sounds really cool. I should raise money either from an Angel Investor or a Venture Capitalist or some other, some other source, some nebulous source of capital wherever these people live.” Um, and what, what I want to encourage everybody here is regardless of your, your background, your product, what you think you need or don’t need for your, for your business, there are two pretty basic things that I- I encourage everybody that I’m talking to, to consider.

And that’s, you generally want to raise money from people who, number one, believe in you and the founding team. And number two, believe in and love your products. And you will meet and probably be introduced to people who may or may not care about you, and they may or may not actually think you’re very good at what you do. Uh, and you may meet people who are very analytical and they are, uh, maybe very bright, but they kind of aren’t super into what you do.

And in my experience, the best and most aligned investors are people who in the early stages of, of a business in particular have a strong belief in, not necessarily that the founder is the only person ever needed to, to lead the business. By no means is that true but that you are a, a significant part of the future of the business. If- if you don’t actually get that vibe from an investor or potential investor, I can already tell you what they’re thinking. And they’re thinking, “Man, this could be a really good business if this guy was out of here.”  Right? And so that may be okay with you. You may actually just want to sell the business to somebody else. And that’s fine. That’s, that can be an okay outcome if that’s what your objective is.

But in most cases, especially in early stage company, you kind of want to stick around and you want to be along for the, the magical ride that you’re all about to go on. So if you have that alignment early on with your investors, that’s going to help and it’s going to make every subsequent conversation about equity and everything else a little bit easier and a little bit, it’s going to inject trust into the conversation. And that is a lot better than injecting very early on mistrust or distrust.

Okay, so, uh, we’re going to touch a few different subjects and I’m going to kind of blow through these relatively quickly and we’ll try to come back to anything where you have a specific question or you want to drill into it more. Uh, and we’ll do that mostly at the end, just so that we can cover the breadth of this, this topic. So this next section here, wealthy people understand the importance of taxes. Ergo, if you aspire to be wealthy, it’s a good idea to begin understanding how this stuff works.

And, and this is important, you think, well, I thought we were talking about equity, why are you talking about taxes? Well, kind of the whole game is like taxes are big deal and for, for many people, especially young people who they- they think, “Okay, I got a job and I have a paycheck and that sort of thing and I pay taxes and that’s how it works.” That’s, uh, you know, hashtag adulting and we’re good. And that’s fine. And that’s a, that’s a part of the, that’s part of the trajectory that, that we often go on in life.

But what you’ll find is the people who, uh, are either investors or, or people who’ve been relatively financially successful, almost everything that they’re doing takes taxes into account. And, and I- I just have a couple of bullet points here to, to illustrate the difference, uh, here. And so that is, there are two, these two like big buckets of taxes. Eh, I’m, I’m oversimplifying but big buckets of taxes, you have long-term capital gains tax rate of from zero 15 or, uh, on the upper end, 20%.

So that means if you, if you grow your business and you sell it for hundreds of millions of dollars, then let’s say it’s a hundred million dollars, you pay a 20% tax rate on that. Okay? So, so that, you know, and- and you made a lot of money but let’s say you owned all of it, then there’s a 20% tax rate. You only get to keep a, you know, 80 million and, and that’s, you’re still, you’re going to be okay. Your kids are going to eat and it’ll be all right. Congratulations. But that, that’s the tax rate. That’s just part of the deal. Welcome to America. Welcome to really anywhere. Um, and but then on, on the flip side, the second one, short term capital gains tax rate which is also, uh, doubles as the ordinary, uh, income tax rate.

And you know, again, you’re all hopefully most of your tax paying citizens and- and we, uh, like you have different rates it depends on what you make. And currently in this year, the, the upper bound of that, if you make a considerable amount of money from like a regular W2 kind of job is, is 37%. Now imagine if for some weird reason you made $100 million, uh, in salary, that’d be kind of a crazy job. But, um, but let- let’s, for- for the sake of, of argument say that, that that were the case.

Now what are you going to pay for, uh, in- in taxes in that scenario, right? Eh, eh, you’re going to pay almost double what the same person who sold a thing and, and was able to be taxed at the long-term capital gains tax rate is, right? So you’re talking about a difference of, uh, like what, and let’s, let’s again, round numbers, almost $20 million, right?

That’s the kind of thing that you want to begin paying attention to because taxes are a big deal and they, when you start dealing with larger numbers and, and for, again, for many of you, when you start talking about equity, you aspire to at some point in the future, maybe sell your company or, or, or, or bring on more investment and you anticipate that you’re going to grow a really big thing. And that really big thing when you have any kind of material transaction, you’re going to pay taxes on that material transaction. And the, the tax rate that you pay is going to, it’s going to affect you differently in different scenarios.

So just know that when we start talking about organizational structure and equity and all these kinds of things, that’s always kind of in the conversation. Always, always a factor that that’s what venture capital firms are looking at, that’s what angel investors are looking at. And you will hear a lot of talk about and, and, and even we’ll mention this now, uh, in the subsequent points pass through taxation and other, uh, you know, ar- are you, are you able to, um, uh, claim particular profits or, or losses on your, on your personal taxes?

There’s a lot of dynamics that happen around taxes and a lot of decisions about how you structure your company and how and to whom you sell parts of your company are driven by taxes. And again, I know you’re like, “Ah, I came here to talk about how to raise $1 trillion,” not to talk about taxes, but it’s, these are kind of table stakes and, and I want you guys to understand that you can’t really understand what’s happening on the equity side until you at least acknowledge that taxes are always in the soup. Okay?

Now there are, again, everything here is, is pretty radically oversimplified, but we have some, some big bucket major entity types here you have a, a sole proprietorship, a partnership, a corporation. Then there’s two, there’s a sub, uh, chapter S Corp and then C Corp and, uh, and then limited liability company. These are big buckets and we’re not going to dig into all of the intricacies of all of them. You can think of it this way. So a sole proprietorship is you going out, you, you want to, you want to do a lawn care service, you want to, you want to wash cars, you want to whatever the thing is.

And you don’t want to form anything. You, if you have to put down a, a, a tax ID, you just put your social security number down and you go to town and you, you, you wash the cars, you mow the lawns, whatever. And in the end you’re, you’re self-employed, you’re going to pay a self-employment tax and all this kind of stuff. So it’s super simple arguably, I- I- I think it’s in arguably the simplest possible structure, but for a lot of tax reasons and what we’ll get into in a second, liability reasons, not always the right solution.

So, so you’ve got everything from a sole proprietorship all the way up to, you know, a C Corp is your, uh, you know, uh, whatever Apple Incorporated. It’s, it’s, it’s typically a, the, the, the most robust of the corporate entities. Your, your publicly traded companies are C corporations and they, they follow a particular set of, um, of- of rules and norms and things like that.

So considerations for entity types. You know, again, many of you already have an entity and, and I’m not going to spend a lot of time on this because this isn’t the point of the talk, but we can’t talk about equity appropriately unless we talk about the entity types. So we’re, we’re building a little pyramid here.

And so considerations for entity types you have, uh, one is liability, two is taxation in three is record keeping. And that this is when you’re starting a business or maybe evolving that business, what’s the right entity type for me? And, uh, liability is the risk that you incur by doing business, right? So whatever you sell, whe- whether it’s a, an ingestible product or it’s a topical product or it’s something that just exists out there in the world and people interact with it in some way. If anything could ever go wrong and could harm somebody else intentionally or unintentionally, doesn’t matter, something went haywire. That’s there is a, there is a, a potential for liability related to that product.

But there’s also a potential for liability related to the conduct of your business. Let’s say that somebody thinks you did them wrong. Maybe you did, maybe you didn’t, uh, they could Sue you. Again, there’s no, people don’t have to have a good reason to sue you in America. They can just sue you. And so there is always a risk whether there- there’s a reason for it or not that somebody could say, “Yeah, I just don’t like, I don’t like Matt and so I’m just going to sue him. I- I think I’m going sue him for wearing a plaid shirt and I don’t like it.” Right?

And that’s stupid and hopefully a- a court would throw that out and all of that stuff, totally fair but it’s really annoying. Uh, if, if somebody shows up at your doorstep and hands you a packet, you know, and- and you’re like, what in the world? This, this is baseless. You still have to hire a lawyer and all that stuff. So there’s liability is everywhere and you’re just managing it, you’re not running scared of it. Again, you guys are entrepreneurs, you’re, you’re, you’re not living kind of a scared, pessimistic life, but you’re aware that there’s stuff that can always go wrong. And, and there’s a lot of different things that you might not even be able to predict everything that could go wrong and it could still go wrong.

So you’re, you’re thinking about liability, we mentioned taxation and, uh, and then record keeping. There are different expectations and requirements around record keeping for different types of entities and I’m just going to leave it there for the moment. Considerations for registration, and this is where is my company? So I made an entity, it’s a C Corp, it’s an LLC, it’s a whatever I decided and now where did I make that? Now, most of you are- are based or your business, either you personally or your business is based in Texas.

Texas, fortunately for you is a very business-friendly state. So in most cases, and again, I’m going to gloss over a whole bunch of stuff, you find that many people who are based in Texas end up forming their entity in Texas because it’s relatively business-friendly. There are some exceptions to that. Certain types of businesses, um, different states have made themselves particularly appealing to and, and there’s all kinds of weird, uh, state level laws and things like that, that can impact whether your business should, should be, uh, registered as a, an LLC over here or, uh, you know, an S Corp over there.

I’m not going to touch on all of that stuff. Uh, there, there is one, uh, one quick, uh, comment that I made here below that is most tech startups and public companies are Delaware C Corp’s and most privately held CPGs or cashflow businesses tend to be LLCs. And there’s a number of reasons for that and we’ll get into that in a second. So the considerations for registration you see here, were there things you consider our business climate, proximity meaning how close it is to you and, and Nexus. Nexus is a tax-related term and that is, you- you can register as a Delaware C Corp but if you’re based in California, you’re still, you- you- you can’t register as a Delaware C Corp and think that somehow clever you isn’t going to have to pay California taxes. Sorry that they thought of that.

So that’s not the reason why, why you do it, the reason why you do it. And, uh, again, very briefly the reason why a lot of the tech startups and, uh, and, and publicly traded companies and large companies tend to be Delaware C Corps is because Delaware has a very unique set of courts and laws that are particularly sophisticated and business-friendly. And that means that you are less likely to be, you know, if your business gets sued or there’s something weird that happens, it’s not going to be left up to a- a- a jury of people who don’t understand business. It’s going to be heard by, uh, by a Chancery Judge in Delaware who hears all these cases all the time. And so that increases the predictability for these large entities. And that’s one of the big attractors there. There’s other reasons, but I’m just going to kind of leave it, leave it at that for the moment.

And, um, LLCs so, so again, to skip down a little bit, LLCs are, most of the CPG companies that you meet will be LLCs. And there’s a number of reasons for this. One thing, uh, especially contrasted with many tech companies, not all tech companies but many tech companies, your business, if run well should make money, right? It’s a beautiful thing, that was one thing I really love about, uh, about consumer products. Like you, you make a thing for X and you sell it for Y and if you’ve done the math right, why should be larger than X? Right? And, and, and then we’ve, we’ve got actual cash to run a business. It’s a beautiful thing. Uh, tech companies don’t necessarily operate in that ecosystem, they are often for a lot of reasons happy to, uh, make a product for, uh, for much more than they sell it for. And, or just not worry about the whole selling it part of it. Right? We’ll worry about, we’ll worry about revenue later because we have a lot of investors and they’re happy to keep writing his checks. That’s, that’s cool, that works in a certain, uh, a certain setting. And you’ll actually meet a number of, uh, of CPG companies, startups in growth stage CPG companies who adopt kind of a hybrid version of that mentality.

Whether they are all in on that model or not maybe, you know, we could, we could debate, but there is, there’s certainly a stream of, of thought there. But in general, we’re talking about LLCs in, in particular consumer product companies that are, uh, or consumer packaged goods companies that are, uh, attempting to, to make and sell or market a product. Many of them will be LLCs and, and for… There’s a number of reasons for that.

One of the big reasons for that is because you’re actually making money and it- it can help from a, uh, it allows and again, we’ll talk about formation stuff here in a second. It allows for you to do some helpful things on your personal taxes. That’s a consideration that you’re, uh, the ability to flow through or pass through, uh, various profits and losses to the owners.

The equity holders of, of an entity can be a real advantage to, to owners of, of these businesses. And then there is another factor that is, um, you- you’re trying to- to take into, into consideration, um, the, what might come in the end and, and you know, one of these scenarios is you think you want to be acquired someday. There can be benefits and this isn’t discussed much but I- I- I’ve talked to a few people around the industry because I’m just, uh, I’m wired to be generally curious. And so I, I’ve, I’ve asked a number of different folks and, uh, why, why is it that our industry, meaning particularly CPG, but even more specifically like natural organic type products. Why are we all LLCs?

Again, on some level you could say, “Well, because of all the things I just said,” and, and, and, and there are a number of other reasons. There is a, there is a also a very practical outcome on the back end, which is it can be very advantageous for a strategic acquirer to acquire an LLC because in the same way that the owners of the LLC benefit from various tax treatments. So too, do the acquirers of the LLC, even if they’re a ginormous, uh, big strategic CPG firm, they can also benefit from the various tax treatments of that LLC because they are likely to kind of hang onto that and use it for their own benefit.

So it’s important for you to know, even someday should you, if you’re an LLC and- and- and you aspire to, to being acquired, that, that can be a benefit. And it actually, for most of you, this is way down the road, can be a point of negotiation with, with a potential acquirer because they’re going to benefit and you might be able to benefit too from that.

LLCs are more flexible but can be more complex. And what, what you’ll hear a lot of business experts say is like, “Oh, you should be a Delaware C Corp because it’s simple, it’s a well trod path and, and, and everybody knows exactly what to do.” That’s, that’s, that has some truth to it but for many of your businesses, it actually does make more sense to be an LLC. What’s cool about LLCs is, uh, and- and again this is probably skipping down to somewhere else because I think I wrote this somewhere else down here. No, it’s, it’s in here. The agreement is everything. And so you have a, a, in Texas it’s called a company agreement for an LLC in many other states it’s called an operating agreement. In Texas, we have to do everything very unique.

All right, so like we- we name everything, we have our own nomenclature for every possible thing. So in Texas, an LLC is a, a- a company agreement and that means that everything about your business is governed by the agreement. Now, many of you are LLCs and I’m not gonna ask for a show of hands, but my guess is many of you, unless you’ve actually raised money outside capital, you probably don’t really have a company agreement. And, uh, again, you’re like, “Ah,” and that- that’s pretty common because like, like getting insurance or doing a lot of other adulting things, we often don’t do it till we have to.

And sometimes that can be a little bit late, but this is a thing you want to consider. And, and certainly talk to your attorney about, you should have an attorney who has and not just your cousin Vinny who does divorce and everything else, but somebody who really knows who understands startup business law and, and that’s really the value. Even if you think you get a great deal on somebody, you’re like, “I found this lawyer,” and, uh, he or she is, you know, 30 bucks an hour and that sort of thing and you’re like, “Yeah, but they’re probably going to be Googling it a- a- at some point.”

So you, you tend to get what you pay for a little bit in the, in the legal realm and you want to just be, not necessarily, you don’t always have to go for the the, the highest ticket price, but it’s a, it- it’s a consideration. You want to work with somebody who knows what they’re doing and this isn’t their first rodeo. But when you’re talking about an LLC, and this, this, we’re starting to get really into the equity part of this, everything is in the agreement. You can have in the agreement that your wife or husband has to kiss you on the lips every morning as part of this agreement.

And if it is in the agreement, so let it be done. Eh, I’m serious like, like whatever the agreement says this, your organization is bound by that agreement. Uh, so, so understand the importance of that. That, that means that every, every relationship you have with a co-founder, every relationship you have with an investor, uh, with an employee, everything along those lines, the, the nucleus of that business is in this agreement. And sometimes it’s a very simple agreement. Sometimes a- as I’m, as I mentioned, it can get pretty complex because everything has to be spelled out in the course of this agreement.

Just so what I want you to know is you take this really seriously and you’re very careful about it because if it’s not in the agreement, it didn’t happen. And if it is in the agreement, it has to happen. And so you want to be really thoughtful about how you construct your, your company agreement if you’re an LLC and how you, how you construct any other agreements that might be ancillary agreements, meaning they kind of touch on or are somehow interwoven into that, into that, that- that base company your operating agreement.

Okay. So you’ve got, I’m going to make a few assumptions here and, and one of those assumptions is that the vast majority of you are or should be LLCs. Now again, there might be some exceptions to that, I’m not a lawyer and, uh, there’s a lot out there. If you, if you want to be a C Corp or an S Corp, there’s actually a lot more out there for you on the interwebs and you should, uh, avail yourself of those resources because there’s a lot of interesting information. But so I’m going to dig in a little bit more on the LLC side because it’s most relevant to most of you.

LLC basic types. You’ve got your single member LLC, which is often regarded, uh, so it’s, it’s called for tax purposes, a disregarded entity. That means it’s you, you’ve taken one step past being a sole proprietorship. We have an actual entity and it’s an LLC, but I’m the only, I’m the only member of that LLC.”

And so it’s, it’s kind of, it’s a step, but for tax purposes anything, profits or losses that happen in your business in more or less just happened to you. Right? So it’s that, that’s why it’s called a disregarded entity. It’s kind of pretty simple. It’s not too complex. Then you get into when you have a co-founder, when you have other partners, other, other people involved in your business, you get into this world of a multi-member LLC.

And these can be, you have these two basic management types of member-managed and a manager-managed often when the people are very, let’s say you have two co-founders and you’re both directly and constantly involved in managing the business, often that means that it would be a member managed because you’re both members of this, of this LLC and you’re, you’re both required to be on the same page about every even kind of pretty trivial decision.

A manager-managed LLC is one where the members, people who own some stake in that have- have, uh, not necessarily abdicated but they’ve delegated a lot of the day to day decision making to one or more managers. And these are managers, maybe it’s the CEO, maybe it’s, uh, some, some subset of executives or board members or something like that. Whoever you decide to are, are the, are these decision-making managers. Again, if it’s in the agreement, that’s what it is.

So, so those are the kind of two basic management types that, that people use. And then you’re going to be taxed as either a partnership or a, a, or a C Corp or S Corp. Again, in a lot of cases, people, there’s a lot of reasons for this I want to dig into it. In this case, you’re often taxed as a partnership and, uh, and, and that’s good.

You can, I, I do want to make one quick, uh, statement. If you are a C Corp, uh, it is very difficult to go backwards and become an LLC. It’s very expensive and painful and it’s a lot of work. Uh, and you will probably pay a lot in accountants and legal fees. It is not as much work and it’s not as expensive to become should you ever need to in the future to go from being an LLC to a C Corp. So you should just know that.

In many cases there are a lot of very big CPG companies that never became C Corps and that’s okay. There might, you know, your mileage may vary, and your circumstances might vary, but just know that that’s, that’s actually a viable option for many of you. So now we’re getting, we’re getting now, finally, you’re like, “Man, it took forever. We’re getting, uh, to the nitty gritty of equity. But it’s important that you understand that stuff because if you don’t understand that stuff, then we’re, uh, we’re just kind of glossing over surface terminology.”

So corporations issue stock, most of you have heard of stock, you may have bought stock, uh, when you were a kid or a- as an adult, LLCs issue units and this is kind of a, one of a number of different, uh, terminological differences that end up having interesting, uh, implications for you and for your business. So, there are just like with stock, there are multiple classes or types of these, these units. And so the, the, the two big buckets are common units and preferred units. Common units are what you own as the founder. And, and common units are good they sound like, “Oh, common, that’s bad. We shouldn’t want common,” common, common is great.

Common means these are the, these are the types of, uh, either if it’s stock or, or units that you can actually do something with, right? So you can, uh, they don’t necessarily have special rights associated with them, but they are the type of stock that one day should you sell your business or even sell a part of your ownership’s stake, you’ll actually be selling a common unit.

Uh, e- e- even if you owned a preferred unit, it would in as part of the transaction be stripped of its special privileges. So a preferred unit is a common unit that has super powers. And those superpowers are governed by the agreement because everything’s in the agreement. Those superpowers could be, uh, there are multitude of possible superpowers, but they, they effectively give the holder of those units special rights and privileges. It could be that if I own preferred units and Clark owns common units that I say, “I get to, I get to have all of the pie until I’m full.” And then when, when I’m fully satisfied, whatever’s left over, I, I decide I’ll share with Clark. Right?

That could be my, that could be my special superpower from my preferred units. That’s called participating preferred stock. And, um, it can be a little bit dangerous for you as a founder, but it’s, uh, there, there are different types of preferences or, uh, preferred, uh, rights that come along with those units.

And so you will, as, when you walked down this path, you will ask your attorney, “Hey, what does that mean?” And so some of the common ones, there are a, a very common one that you’ll see in almost every case is some form of a liquidation preference. A liquidation preference, so liquidity is making things that, you know, if- if you have a house that you can’t sell, you are illiquid. As soon as you sell the house, you have experienced liquidity, meaning you can convert that into cash. And so when, when you have a, anything dealing with liquidation is typically selling something or moving something into a, uh, fungible form of, of, of cash.

You’re, when you start talking about liquidation preferences, it means typically it’s a downside protection that an investor might ask for or demand as part of a financing. And they would say, “I want to get all of my money back.” Let’s say, let’s say this investor puts $1 million in and they have a one X liquidation preference. That means you operate the business for a few years, things go well for awhile, then turn, they turn South. Things aren’t looking good. You decided to sell the business for not much more or maybe even less than what you, it was worth whenever you raise the money. That’s, that’s a kind of a down round scenario or a, a little bit of a fire sale scenario.

In that case, if, if this investor has a one X liquidation preference, that means that they let they put $1 million in. That means that they’re get the first million dollar if- if, in- in the waterfall of rights and all that kind of stuff. Again, in our simple example, they would get the first million dollars out. That means if you sell the business for $900,000 you get nothing, they get the first 900,000 because you didn’t get to their full one X liquidation preference in that scenario. You will see at times in certain financing scenarios, a two X or in rare cases a three X liquidation preference. That means that an investor is saying even in a scenario where things don’t turn out, you know, all, all ponies and rainbows and, and everything beautiful like we hoped I’m still going to get twice or even three times my money back.

And that again may be what they consider to be and it might even be what you consider to be a fair shake for the risks that they took because they actually put real money into your business and all that stuff. But you should know what it is, and you should know that in a scenario where somebody puts $1 million in and they have a two X liquidation preference and you sell your business for $2 million. Again, in our very simple scenario, you won’t get any money.

And so that may be, you may be like, “Yeah, but the experience was so worth it. It was beautiful every, every part along the way.” That’s okay. I just want you to know that that’s how it’s going to go. So again, we kind of talked about that corporations use bylaws, board minute books, uh, et cetera. LLCs use company agreements in Texas or operating agreements in many other states.

Then now we’re, we’re down to like equity. What, as you say, I, I, I want to own equity in this thing. Again, we’re talking about LLCs here primarily. Many of you are familiar if you own equity in a, in a, in a C corporation, you own stock and, and just like you would buy and sell stock and on the NASDAQ or New York Stock Exchange or things like that, it’s kind of similar. You don’t have a public market, so there’s not the same level of liquidity and there may be some other, some other challenges around that.

But that, that world kind of operates the way that you imagine Wall Street does. When you’re talking about an LLC and you’re talking about units, there are kind of these kind of three big buckets of interests in your business, and different, different people, different stakeholders will have different interests in your business. So the first big bucket is the capital interest. And this person or this entity has a current, uh, they share in the current value of the company. So you can think of this as typically, uh, you know, founders and investors are going to fall roughly into this bucket. They, what they own, they own today. So the, the, the thought experiment is if you were to have, if you were to liquidate all the assets of the business today, who would get any money?

Right? So let’s say your business had $1 million worth of assets and everybody just decided, “Oh, this is so terrible, or it’s not worth the trouble, and we’re going to sell everything at a garage sale and we’re going to split it up, uh, according to the agreement and how we, how we’ve, how we’ve divvied things up, uh, to this point.”

The people who have a capital interest in that business, that million-dollar business will get their pro rata or proportionate share of, of that. And so that’s, that’s really what that, that capital interest is. So these are people or entities that have an ownership of assets of the business and typically in exchange for cash invested or if you’re a founder because the business was effectively worth like nothing when you started it. That’s how you kind of eek your way in even if you don’t have a ton of money, uh, you, you get, you get a special privileged seat at the table because, uh, even if you put in a dollar and the thing was worth, uh, not much, then, uh, then- then that’s kind of how you, how you merit what you, what you own.

There’s an, the second class of, of interests here in an LLC is called a profits interest. And this, you know, compared to the capital interest is an interest in the future growth of the company. So this is an interest in future profits and appreciation of assets. So often profits interests are granted to either particular key employees or some, in some cases service providers or other people who might come along in the world in the trajectory and the story of the business at some later date. Right? So maybe you weren’t a co-founder, but you were a key employee who came along at a pretty early stage of the business and you were really instrumental in, in the growth in the, in and all of that stuff or you planned to be.

So that type of person or maybe it’s a service provider and they, they come along and your business is worth 500,000, maybe it’s worth five million, who knows? And, and they come along and, and they’re going to help you take your $5 million business and make it worth $50 million. Well, their profits interest is, they would have the opportunity to share in the gain the appreciation of assets from that $5 million valuation up to, in our hypothetical scenario, the 50. So they would gain their whatever their percentage would be from five to 50 or $45 million, right? So they’re not going to get all the $45 million, but if they owned a, a fraction of that, again for round numbers, let’s say they own 10% of that, then they, they would, their appreciation, their, their interest would be four and a half million dollars. And that’s, that could be a lot of money, right?

So that would be a very significant, uh, profits interest grant, which normally they would not be that large but it could happen. Again, it’s an LLC, whatever’s in the agreement is how it is. So you have, you have these profits interest in a couple of notes here, these can be either fully vested at the time they are granted or they can be subject to vesting. Vesting is where you give somebody something, but you don’t give all of it at once.

You, you spread it out typically over a number of months or years. And so, the way that typically works is in, in a standard startup scenario, you might, uh, you might grant someone a, let’s say in, in this case it’s a profits interest and it vests. He- here’s very standard startup terminology, it’s going to vest over a, a four-year vesting schedule with a one-year cliff. And so, what that means is for one year or 12 months, you get nothing. But if you, in fact you’ve done all the things you said you were going to do and you’re still employed and everybody loves each other, then on like a- at that one year anniversary date, you would be granted a quarter, uh, of, of whatever interests you might have- have received.

After that, depending on how it’s written in the agreement but, but a standard scenario might be that you would get an additional 136th of the remainder of that thing over the next 36 months that would be granted on the anniversary of, of whatever thing. So if you, you know, again, let’s say you don’t stay there for the full four years but you’re there for two years, then, then you have effectively kind of received your interest for half of, of whatever was granted. So hopefully that makes a, at least conceptual sense.

And, uh, it’s important to note that in these situations, you’ll note here in the, in the notes that IRS 83 B Elections are important if, if anyone, either an employee or, or even maybe a later founder type person. If somebody comes into the business and there is an appreciable asset, uh, their, their interest in that business is going to grow over time. And you, you can imagine, eh, so in our scenario before where you had a one-year cliff and then, uh, every month after that that you were employed, you got a little tiny additional sliver of ownership in the business.

In, in that scenario is the business when, when you were granted that, let’s say the business was worth $2 million but things go really great and four years later the business is worth $20 million. So what could possibly be a gotcha? Remember we started off all this stuff talking about taxes is you can actually, your interest could be, is a fraction of the value of the business at the time it was granted. So you’re, you’re, you’re 148th or 136th or however it’s structured. Um, could, is, is taxable theoretically, is taxable at the value of the business and the portion of that.

And you think, “Man, I’ve got an ownership stake in a thing, which is awesome but I might not get paid for years and, but the IRS says I got to pay taxes on it now.” So this is why 83 B elections are important because you send in, you fill out a form and you work with your attorney and your, if it’s an employee situation, everybody has to be involved and you have a window, you don’t get to take forever to do this, you have a very finite window, you fill it out, you mail it into the IRS and it locks in the value of your, in this case are in this scenario, your profits interest so that it’s not taxable. It’s, it’s only taxable at the rate, the value of the business today.

And that in most cases for a fast-growing startup means you like your, you definitely want to be taxed at the tiniest rate possible, not some ginormous rate when you don’t actually have the cash to pay the taxes on it, that- that’s where things get really weird and sticky and so you want to avoid that.

Again, we’re not going to answer all the questions tonight but I want you to be aware of some of these things so you can be like, “Huh, I should probably learn more about that.” And, and the- the last bucket here is deferred or incentive compensation and in LLCs, this is different than, uh, many of you may work in, in the tech space and so you have a, there’s all kinds of interesting and exotic types of incentive compensation, especially in the tech space. But you have, uh, restricted, uh, stock units. You have, uh, all kinds of stock options in, in, ISOs and all these different, there’s a lot of acronyms.

And more or less, most of those are granting a particular person the privilege of purchasing stock at a given price at some date in the future or under some, some set of conditions. It’s a little bit different in the LLC world where, again, we’re not going to get into it because you don’t have stock per se and everything is bound by these agreements. And so what tends to happen is some form of, you can have, again, for the right circumstance, there can be a Phantom equity component where it is as if you own equity but it doesn’t show up, it doesn’t have the same voting rights. It doesn’t show up on the books in the same way.

The, the positive is it’s super well, it, it can be a lot of trouble for the company to set up, but in from the employee or other key stakeholders perspective it can be relatively easy. The downside is back to the tax thing, it will be taxed as ordinary income. So that means even if you were to have a significant, uh, windfall someday in the future, your business does super great and, and you have this key employee and they own a, a nontrivial amount of the, the, the company and you make a lot of money and they make some money and that sort of thing. That’s awesome.

Years, if it’s a capital interest it’s going to be taxed at the long-term capital gains rate of let’s say 20%. There’s, if it’s a significant amount of money is going to be taxed at whatever the highest threshold, ordinary income tax rate, it’s like 37% something like that. So you just know there’s tradeoffs from a tax perspective from that a, that side. Now moving forward, one very, very common way that people raise equity, especially in these early stages is, is through the form of convertible notes. And convertible notes, you hear some about them, they are promissory notes. That’s the kind of legal definition like I’m making a promise in and you’re hopefully going to fulfill your, your end of the bargain. So a promissory note or, or a form of debt, typically it has, it has some interest, uh, nominal interest. And you know, 5%, 6%, whatever, whatever the going rate is that converts, uh, or in plural con- convert to equity under certain conditions.

Most commonly a, and you’ll see this in a qualified financing and, and a qualified financing in your agreement will be, uh, enumerated. So what constitutes a qualified financing? Maybe it’s you raise $1 million, maybe it’s you raised $250,000. Maybe it’s you raise something, any amount of money at a particular valuation, whatever, however you and your attorney define what a qualified financing is, that’s what a qualified financing is so, or, or a sale.

And under specified terms, most commonly, the- the two most common terms that you’ll see in convertible notes are a discount and a valuation cap. A quick note on convertible notes, the reason why people like convertible notes is A, especially for LLCs, you don’t necessarily, the holder of a convertible note doesn’t necessarily need to get a schedule K1, which is a kind of an IRS form that, that owners of a business of an LLC received to reflect how they, their, their personal taxes will be, uh, effected by your whatever’s happening in your business.

So you don’t have to get a schedule K1and lesson until it converts. So, so that’s a little bit simpler. And then the other thing is, is they’re, they tend to be not as complex. So you often have fewer legal fees related to them, legal fees can be substantial if you’re doing a qualified financing, it’s not uncommon to pay tens of thousands of dollars for these kinds of things. And, um, certainly it could go up from there depending on how much money you’re raising. And, uh, you’re, you’re trying to partner with people who believe in you early and who are willing to go out on a limb on your behalf.

And what that often means is these people are sticking their neck out for you before other big check writers ever maybe even ever knew you existed but certainly before they were willing to write the same check. And so the basic concept here is, you want to reward those people who took on more risk on your behalf with a few incentives that, because if you gave them no incentives then why would they write a check a year before you got money from this other qualified financing?

Like they’re kind of rubes if that’s the case. And you, you don’t want rubes investing in your business. So the way you justify that is you say, “Hey, uh, if you will invest in this, uh, in my company via convertible note at whatever, whatever the terms, I will give you A, a discount meaning whatever, wha- whatever that same amount of money that you invested would have gotten you in this next financing you’re going to get, let’s say it’s a 20 or 25% discount, you will get 20% or 25% more shares than you would’ve gotten if you’d just come along later and invested the same amount of money.”

So there’s a little bit of an incentive. Okay, I get a little bonus. And, and so that, that part’s really cool. And then there is also a valuation cap and the valuation cap is a, a protection for that person who invested early that they can’t be unfairly diluted, not deluded as in confused but diluted as in like a solution in, in water or something like that. That their, their steak can’t be messed up by you doing some weird financial engineering type stuff.

So you can’t go out and say, “Oh, um, yeah, I, it turns out I’m going to raise, uh, I am going to raise some money.” Let’s say you put in, uh, this tiny little business that hasn’t, is not even doing super great. And they come back to you and they say, “Yeah, we’re going to raise money at $100 million valuation.” Right? Uh, and, and I’m, you know, like, but we don’t sell anything and all, all this kind of stuff.

And you’re like, “Huh, that seems weird.” And you know, their, their cousin Vinny is going to put in $11 at $100 million valuation so that it locks in that valuation so that you get diluted and that your, your ownership stake ends up being a fraction of a fraction of a fraction. So what you do is you protect that person against, uh, malfeasance, uh, in, in that, in that case, by simply saying, all right, there’s going to be a, a valuation cap that says, um, “Whatever, whatever you raise that even if you, let’s say it’s a $5 million valuation cap and things do go awesome for your business and it’s $10 million, like you actually raise money at a $10 million valuation? Sweet. That’s great.”

But that person who believed in you before everybody else is investing as if it were five million, right? So that means that they’re going to, they’re going to get, a, a disproportionate but they would argue proportionate share for the risk that they incurred by investing you far earlier than everybody else. So hopefully that, that again, uh, it’s not going to answer all your questions but hopefully it gives you a lay of the land there.

So wrapping this up, ownership and control, maybe two different things, I- I often hear this from founders where they are petrified of selling more than 51% of their company. And so I, I often remind people that ownership and control are not the same thing. So ownership is signified in the percentage of the company someone owns while control or power, uh, is reflected in the ability to direct the course of the business. For example, board seats, voting rights, liquidation preferences, drag along rights, ability to hire and fire executives and other things. So you could own, you know, a, again, easy example, Jeff Bezos owns, you know, whatever, 13%, 16% of Amazon, but he clearly controls Amazon, right? So he doesn’t own 51% of Amazon.

Mark Zuckerberg does not own 51% of Facebook, he created a special class of stock that gave him 10 votes for every share so that he would always in perpetually be able to outvote everyone else who disagreed with him. Again, he had a lot of leverage in that negotiation. Um, so I’m not saying that you’re going to necessarily go that path, but you need to understand that those are two separate scenarios and the percentage of the business that you own does not necessarily reflect your control of the business. I’ll give you a really easy example. You, and this is a common, like what, what I consider to be relatively rookie mistake.

So if you have a board and everybody on the board has an equal vote, um, and, and there’s, let’s say there, there are, uh, there’s one founder and you, you bring on an investor or investors and those investors as part of the financing get two board seats. And you think, “Hi, I won, I own 80% of the company and these jokers only own 20% of the company.” But if you don’t have other protections in there and you have a board meeting and it comes time to vote. And one of the people says, “Yeah, I’d like to vote on who should be CEO.”

And you think, “Huh, I own 80%.” And you’re like, “Eh, yeah, you do. Uh, let’s vote. It shouldn’t be. It shouldn’t be anybody here.” Right? And you’re like, “Ah,” and then they vote and you lose two to one. Right? So that’s power or control and that’s different than the percentage that didn’t, that had no bearing on the percentage of the company that you owned. It just had, had a lot of bearing on your ability to dictate the course of your business.

So you want to be aware of some of these, these things. I’m not saying, and I’m not doing this to scare you or to make you paranoid but I, I really love making startup founders aware of these things because it levels the playing field. Again, if you’re a venture capitalist, you see a lot of these deals, like a venture capitalist would be like snoozing in this. They’re like, “Yeah, yeah, yeah.” Everything you’ve said is like, well, you know, junior level of finance or something like that, whatever.

Um, but for most startup founders, this isn’t what you, A) this isn’t your background and B), it’s not why you got into this. So, it’s really, I think, important and valuable for you guys to have at least a pretty solid baseline understanding to know what you’re talking about so that when the time comes you aren’t duped. And, and I think that’s really important. So last couple of points here. Basic typical fundraising sequence. And I want to stress basic typical, this is not probably how it’s going to go for you and your mileage may vary in a lot of ways but it’s actually quite simple on some levels.

Number one, hire a lawyer. Now again, most of the time in my experience too, and this list will come before one. But I’m just saying this is your id-, this is your platonic ideal of a fundraising sequence that you knew a lawyer and you had interviewed lawyers before you ever got to this point. So number one, you hire a lawyer and hopefully, again, like I mentioned before, they have actually done some of these things before. And number two, receive investor interest, uh, easier than it, uh, or not as easy as it sounds there.

Number three, negotiate the principle terms over coffee. And again, this is the thing, I tend to some of you know, I used to teach, uh, college and, and, and so I, I do, I think it’s important for people to learn to, to, to… on stage at Project NOSH and all that kind of stuff. That’s cool. That’s a really great skill. But I, I also think it’s equally important for people to know that perhaps it’s happened, I’ve never met anybody where this was the case. A lot of founders believe if they give the world’s greatest pitch that a rich person is going to walk up to them after the speech and say that was so moving and they’re going to get out their checkbook and write them $1 million check right there on the spot.

And I don’t know if that’s happening, typically what happens is, you may through that or some other circumstance, peak the interest of a, and, and, uh, uh, some investor type person. And then you’re going to have a conversation over coffee and that conversation if you’re really awesome talking about your business in front of the bright lights on stage and you can’t explain your business and answer questions in a, uh, in a pretty smooth way over coffee, that person’s probably not going to invest in you.

So, if my recommendation is get really good at talking about your business over coffee and that’s probably a more practical and useful fundraising skill then, then putting on your, your Sunday best and sequence in standing up on stage and pitching. So, uh, after you negotiate those principle terms again, because once you involve lawyers, and this is no offense to lawyers, I know a lot of them, most of them are really great people, but lawyers tend to complicate things. And, um, and, and they should, they, they are advocating on the, for the best interest of their clients.

But once you get the lawyers in the room, things that seemed very simple and straightforward all of a sudden will not, will no longer be simple and straightforward. And so you want to make sure that we all agree the principles in the deal that we have a verbal like, yeah. So we were thinking this, were you thinking that? And, and we get the basic outline of that and then we involve the lawyers. So, um, that’ll save you a lot of legal bills and heartache. The, uh, so the parties, the lawyers negotiate the details back and forth, quibble over the finer points and then parties sign a subscription agreement and then, uh, and then people with money, wire money to your bank account, and then you get back to work.

So you can, you know, again, go out and have, have a drink, have a special celebratory dinner but there’s a lot of, I, I feel like a undue attention put on, uh, so-and-so raised this amount of venture capital money or so-and-so got this investor or that sort of thing. That’s cool that you don’t see those things, same like stories being published in the, in the press. Like, you know, uh, you know, so-and-so, like, you know, Brian, Brian got a loan for his house and you know, our way, like, like why we are celebrating, celebrating that in the same way. Like he got a really solid interest rate. Like you go man, like that doesn’t, that doesn’t end up being front page, uh, news in the business press.

But kind of that’s what VC money is, right? It’s like, “Oh, you got a mortgage.” Like, and on some level, if you’re, if you’re being cynical, it’s like, “All right, you just got some new bosses.” Um, so that’s excellent news if you have the perspective that you just got rocket fuel from people who expect you to have this rocket take off. And as long as everybody’s clear about that, that’s, that’s awesome. Hopefully it goes and takes off but don’t necessarily see the fact that you raised some money as an end in itself because it kind of isn’t.

And it may, it’s going to ratchet up the stakes of your business and that’s going to make you uncomfortable at times. And that’s, that’s okay, that may be what you signed up for. I want you to be aware that that’s what you signed up for. Okay, and then the last thing, uh, that I just wanted to point out, cause I see this every now and then and this is kinda random and a little bit technical, but I think it’s important.

Um, most of you don’t know, but everything that we talk about when we’re talking about equity and securities is all subject to something from the Great Depression, right? So the securities act of 1933, uh, is referenced all over the place. And this is the act, this is kind of the FDR era act that governs everything related to all these financial securities that are flowing in all kinds of directions across our economy.

And so, if you’re raising money, the activities that you’re engaging in are subject to this big sprawling act. And now, fortunately, you don’t have to read the whole thing and you don’t have to be an expert at all of those things. But if there’s one little sub section of it that I, in- in particular want to point out, and that is regulation D rule 506. And again, you have a good lawyer, they’re going to know this stuff backwards and forwards.

And number one is, uh, in compliance with this, uh, you can’t advertise your offering generally, that means don’t post on LinkedIn, “Yo, peeps, Raising money. Um, like you want to write me $1 million check, do it.” Right? So you can do that and probably nobody’s going to take you very seriously and that might be in your best interest in- in this moment. But you are technically in violation of this, the spirit, maybe the letter of, of that, of that act and, and this, this subsection.

And the reason for that is, you are allowed number two, to only approach people who are qualified, accredited investors. Uh, and up to 35, and this is a, this is an actual term, sophisticated investors. These are non-accredited people who know what they’re doing financially. And again, that’s kind of a rare thing but it’s, it- it happens. An accredited investor, just so you know, is someone who has, uh, more than a million dollars in assets outside of their primary residence.

So again, if they have a very nice house in Tarrytown or Westlake but have no money in the bank and no other investments doesn’t count, right? Uh, and, and so you have to have, uh, enough money and the principle here is – investing is a risky activity. Again, how did the, let’s, let’s go back to the great depression and the speculation that caused some of that, right? So people were putting their entire life savings in these, uh, pipe dream scenarios thinking, I’m going to, I’m going to get rich, I’m going to, I’m going to strike gold with all these different speculative land deals and all this kind of stuff.

And people got wiped out. And so the spirit of this act is pr-, is to protect people from getting bamboozled. And so one way they do that is by saying the only people you can sell your, your equity to legally are people who can afford to lose it. And hopefully, uh, people who understand what they’re getting into. So, um, that, that’s why that exists. And, and, and then you’re typically your lawyer must file a form D with SEC, which is a thing that usually has very little information but list a few of the principles involved in the thing and for other stuff.

So again, we’re not trying to be comprehensive about everything but at least to give you a baseline vocabulary around a lot of pretty complex, uh, legal CPA related stuff that most of you never wanted to go to law school or be an accountant and you’re like, “How did I end up here?” And you’re like, I just wanted to make popsicles, you know, and like, uh, why do I have to know this stuff? Now fortunately you surround yourself with really smart people who are experts at this.

It’s important I think for you as a founder or key person involved in a business to understand at least a modicum of what’s happening so that you can ask in- informed questions of your advisors. So, all right, with, with that, let’s, uh, I’m gonna, I’m gonna transition and see if, uh, let’s see. So, so Dustin, uh, you, you get to, to kick off here. Um, the, uh, is there a governing law for vesting ranges or is it the Wild Wild West?

I can make it up, uh, on some level, yes. So everything, going back to the very first thing I said is about aligning incentives. If, if I, if I give somebody a vesting schedule and it’s 10 years. And so they’re going to, they’re going to only get a fraction of a fraction of a fraction every, every single time over the course of 10 years. You may think you may be too clever by half where, where you think, “Huh, I showed them I, I didn’t give them too much upfront and that sort of thing.”

But then the reality is you might actually create a scenario where you have created a perverse incentive where they go, “Eh, never mind, I’m never going to get my share. Dustin doesn’t care about me or he doesn’t recognize all my contributions over this set of this early set of years or these milestones.” So it, it tends to be you want to be creative but maybe not too creative about or, uh, about how you structure these things, but then know that there are certain norms in the industry. So, so a three or four year vesting schedule by far are the most common of the, of the vesting schedules that you’ll see in a variety of different, different businesses.

Um, mainly because we live in a world where people don’t work for one company for the rest of their lives. Most people who are going to work for a startup in particular are not averse to some degree of risk. And they know that this might not work out. And the- the whole thing could dissolve or maybe there’s a big pivot and all this kind of stuff and the company goes in one direction and they go in another direction. So they want to, they want to be aware of, they should be aware of what they’ve signed up for. But at the same time you want to treat them fairly. So if they help you get to whatever mountain top that is, you just want to make sure that, that you’ve created an incentive that aligns well with that.

AUDIENCE           You talked about, um, some form of equity that someone would have early on in the company that they would, um, be vested that, that equity or those shares that then they would be taxed on but then not necessarily have the money to pay the taxes from that investment or they’d have to come out of pocket. Um, what? (laughing)

BEN                   Right. Huh? Yeah, that’s pretty scary. So that, this actually not as uncommon as you might think this is, uh, if, if you don’t file the proper paperwork. And so like I mentioned this 83B election, uh, in, in the proper window, I think it’s like 90 days. Does that sound right to finance people 30 days? Uh, 30 days? Um, it’s very short window. Uh, from when, when that grant or whatever event happens, then, uh, you can, you can potentially be, be liable for that.

Now again, consult every, all the professionals but it’s, it’s not, this is actually pretty common. Again, even for, you hear a lot of things about like tech or let’s just take a tech startup scenario. You, let’s say you’re, you’re a part of the early team at, at Airbnb and, and things are awesome and you guys are worth $50 billion and all that kind of stuff, and now all of a sudden, um, it’s time you want to, you want to, uh, sell some shares on like the secondary market because they haven’t gone public yet and this sort of thing. It’s like, “All right, I’ve got these stock options.” They like, I can do it now.

And, and somebody comes to you and they’re like, “Sure, okay, you can buy, we’ll, uh, we’ll do the, do the transaction, but you actually have to buy your stock first.” And it turns out that your stock is worth, uh, $5 million. And so you’re like, “Um, let me, let me check my couch, and I don’t have $5 million lying around.” But you might not actually have the funds to buy the very stock that you own, uh, which in turn you would then sell, hopefully, you know, for, uh, an appropriate gain and all those sorts of things and then pay taxes on. So there is, there exists an entire industry that says, “Oh, I’d be happy to help you out with that, with that $5 million for a piece of it.” Right?

So they’re like, this happens a lot in, in, in a lot of startups scenarios and what you’re trying to be careful about is not incurring various obligations, tax or otherwise when you don’t have the money to pay for them because that, that’s really tragic, right? You think, “Oh, I should be super excited.” But, “Ah, I don’t have the money to pay for the thing that I’m really super excited about.” And, and so that same thing can happen on the, on the tax front if you don’t consult with the right people, uh, along the way.

And so yes, you can actually incur a tax bill that you do not have the money to pay for and that’s not going to make you happy or the IRS happy. So that’s why, again, that’s why you involve the, the right professionals, uh, all along the way to make sure that, that you’re doing things right, you’re doing things by the book and that you don’t get into a situation that an unforeseen bad situation.

AUDIENCE           So, um, talking about the convertible note, you don’t really have like a valuation when you issue convertible note, which makes it a lot easier. One of the questions I’m getting a lot from potential investors who aren’t familiar is will, “So how much equity will this convert to?” And it’s like, “I don’t know because we don’t have a valuation right now.”

BEN                   Correct. So, so that’s where your, your valuation cap that you put into that document sets a default valuation for them. Right? So, so perhaps in that conversation, and again, not every convertible note has a valuation cap, but some flavors of it do. Many of them do. And so if they say, “Ah, I would invest in this, if this business were worth $1 million, I would invest in it. If this business were worth $10 million, eh that’s a little too rich for my blood.” Right? So that can happen. And, and so what, whe- wherever you set that valuation cap in negotiation with your, your investors is one way for them to get a clearer idea of the highest it could possibly go.

Now there, there is a scenario where you don’t set one and, and then you’re right, eh the answer is it depends. Because nobody knows, right? So, so imagine you’re, you’re, you’re rolling along and you’re, uh, you know, you’re, you’re some, uh, hot shot brand and, and, and, but you’re tiny and then you get picked up by these huge retailers and things just start going gangbusters and you go from being worth nothing to being worth a ton pretty quickly or, and there’s all this investor interest in and it’s a frothy market and all that happens, I mean, ultimately you may, you may say, “Oh, we’re now worth, uh, e- even more money.”

Um, and so that’s, that’s going to be a negotiation between you and your investors. I will say this, this is a common pitfall that people assume that it is, that the highest valuation is the best valuation for your business. And that is not the case. And you can see like the internet is littered with stories of people who raised at, you know, $1 billion, uh, valuation or whatever the thing is. And then like crashed and burned and then when you have to raise after you raise something at $1 billion and then you have to go back to those investors or other investors and you’re not doing so hot, and they say, “Yeah, I was thinking you were worth maybe like a hundred million dollars,” then you, you enter a death spiral really quick.

And, and so you ideally, just like in every other part of the business, you want to grow in a systematic and thoughtful fashion and it’s usually not in your best interest as a founder to grow too quickly. Uh, and to get out over your skis as they say. Because if you go from I’m worth, you know, $200,000 to I’m worth $200 million in 18 months, buddy, you better put up or shut up because you’ve got a lot of expectations on you at that point because your, guess what? You’re the next thing.

And so if you can deliver on that more power to you but most people can’t. And, uh, and, and so these are all, these are all considerations, but ultimately there, there’s not, there’s not one that’s sort of the nature of that deal. That gets determined. You’re kicking the can down the road to the next qualified financing.

AUDIENCE           So is it okay to be like, I don’t know?

BEN                   It’s always okay to be like I don’t know. Yeah. I, I, if, if I don’t know, is there, is the honest and right and truthful answer? That’s the answer.

AUDIENCE           I have a question in regard of the option pool first, is there a significant differences between the world, the tech world and CPG and B, is there any downside to start as small as possible when you want to give out, uh, say whatever. I’ve, I’ve assigned 3% to the option pool, which is considered small in the world of tech. And then you can just, just as a protection for the founder of, uh, dilution for in, in, in, in future financing rounds.

BEN                   Sure. Yeah. So ev- uh, very quickly. So an employee, usually employees, but it’s an incentive or option pool is a set aside amount of shares or units that, uh, that you allocate to current or future employees are key contributors, uh, to the business. The most, uh, the most common percentages that you see are like 10% to 15%. Uh, you could go, go less if, again, you had not very many people that you… 3% would be a very small number because it wouldn’t take very many people giving them even, uh, a modest amount of equity to eat that up pretty quickly.

AUDIENCE           You can always assign right at any future dates, a larger pool?

BEN                   You, you can correct. So typically you create a, you create another option pool with every subsequent financing round and again, in like truth in advertising, many investors will require or expect that to come out of your share as the founder. It’s not necessarily something that they are particularly interested in contributing to. Now, some very progressive, fair-minded people, might take a, a different, uh, a different approach to that. But if you start again, if you, eh, like with each of these kind of rounds, you are, you’re, you’re, you’re taking a bite out of your own, your own part of the pie.

Sometimes that’s worth it. Again, if you have very strong contributors who are integral to the business, then, uh, and you want them to act like owners back to the very first point that I made, then often that kind of equity ownership can be a really important motivator for those people. But you, again, your mileage may vary, your, your, your attorney who’s, who’s working on whatever deal will likely have very strong opinions about this.

And, uh, and sometimes when you get, when you get sort of larger, you may even have investment bankers involved in some of these, these things. And, and investment bankers will have a lot of o- opinions and, and knowledge about those areas. But, um, you can do it and you can do it early on but it’s important for people to understand that what you’re doing when you are raising equity, you’re not, you’re not, in most cases, you’re not losing shares, right? So if you own 10 million shares, you’re like simple company, there’s 10 million units and you’re up, you own 100% of it. So you own 10 million units, you’re not giving up your units to the, to other people. You’re creating new units. Uh, the, the company is creating new units that are then granted to or sold to people at a given unit or share price, something along those lines.

So you’re actually creating new things that did not exist. So at the end of this financing round, maybe you started with, with 10 million, uh, shares, you might have, uh, 15 million units, uh, at the end of that. So you’re not taking yours away. Your percentage of the total pie is diluted but you, yourself didn’t give up any indi- individual units. And, and again, you would rather have, uh, 15% of Microsoft than, uh, than 100% of Bob’s Computer Repair, right? Like, so sometimes the percentages can be a little mis- misleading. You’d rather have a smaller percentage of a ginormous pie than, than own the whole tiny pie.

AUDIENCE           The, sorry, just follow up. The, the question was in regards of the, the unassigned shares of the option pool, that might just roll over into the next financing round.

BEN                   Yeah, the unassigned shares get, uh, are, are, uh, are the property of the company, the Board of Directors typically has autonomy to determine what to do with those. So again, in an LLC, everything is subject to the operating agreement. Sometimes that can be specified, uh, like here’s what happens to any unassigned shares, uh, or, eh, unfortunately, again, for most founders, they assume, “Oh, I get them back.” Uh, usually you don’t get them back. I mean, maybe, maybe you get them back on under some weird circumstance, but most often it reverts to the company, the company’s ownership and they, they sort of exist out there in the ether and they’re not, they’re still there, but they just haven’t been assigned to anybody. So they don’t, they- they typically don’t even get eliminated. They just like exist.

And it’s, it’s really esoteric. But, um…

AUDIENCE           And, and then at the exit, somebody acquires the whole thing. What happens with those shares that are not assigned?

BEN                   Um, depends on a lot of, a lot of factors, depends on what happened along the way. Let’s assume that it’s a very straight forward scenario and it’s the company, you could argue that that then gets redistributed pro-rata to the ownership of the, of the company. And if you own 11% of the company then at that point you get 11% of whatever the surplus assets might, might be available. Assuming again, not to get like overly technical that there’s not a bunch of escrow and other things that have made the deal very complicated.

So there’s, there’s, thi- this gets like especially once you start talking about mergers and acquisitions, it gets very exotic very quickly.

AUDIENCE           This might be a little senior but I heard recently about reverse investing and it’s another way to avoid taxes. And I was curious if you could…

BEN                   Usually, um, so, so the, um, the, my, my understanding, again, I’m not an expert, but, but the primary reason that reverse vesting exists is to theoretically to align the incentives of the founder so that the foun-, like sometimes an investor will, uh, have a condition of reverse vesting on a founder.

So, so you’re the founder, you already own your fully vested like, whatever you own, you already own. You didn’t have to earn it, you didn’t have to work for another period of time. But they might say, “You know, I think the Clark is so valuable to the business that I don’t want him to just, uh, run off and do something else.” And so I want to give him an incentive to stick around. Again, I- I see this as not a particularly founder friendly scenario in mo-, or at least the spirit of it is usually not very founder friendly.

But there, there might be circumstances where it solves a-, another set of problems, but, but usually what it is, it’s an insurance policy on the part of an investor to make sure that key people who are already fully vested don’t leave, that, that’s what is most often used for. There could be other uses for it. And again, there may be other folks in here who have, have thoughts on all that.

AUDIENCE           I’m looking at joining a startup. So I was curious to know, I know it’s hard to say specifically, but ballpark, they asked me what kind of equity I should be looking for and I don’t know what to tell them. Um, and I’m not going to be getting paid any base, it’s just a commission I get paid based on the amount of, uh, software I sell. But can you give me some Ballpark kind of parameters of what type of, um, percentage or equity and employee or if someone’s hiring someone into the company what they should be asking, what they should be offering to that person?

BEN                   Yeah, I think that’s a really good question. On one level, there’s not an answer to it. Uh, on, on another level, there actually is an equation. You could imagine, so let- let’s say every person is unique, every person who comes into the business brings their own unique background and skills and expertise. And there’s some people who, um, maybe they’re just like, they’re relatively replaceable. You could like, “Ah…” Like there would be a hiccup of a day or two and then we’d be back, you know, everything would be back in, in business exactly as it was before.

Well, that person’s not maybe bringing a tremendous amount of value. If, if somebody else is like super integral to the business then they bring more value. The way from thinking of it as, as an employee or somebody who’s negotiating a, a deal, I think sometimes it’s helpful to think about the percentage. You’re taking a risk theoretically, uh, by choosing to work for a startup, you’re particularly taking a risk by not taking a salary, right?

Now, let’s say that in, in your other life, your prior life, you only ever worked on a commission only basis. So that’s not maybe not like even super unusual to you. And let’s say you’re high flying salesperson and you say, “I, I make a 20% commission on everything I sell and I take no salary and pay my own expenses and I’m a, I’m a total like you know, headhunter kind of person. Like I’m- I’m a mercenary, I, I, I eat what I kill kind of thing.”

And, and there are certain salespeople who, who might think that way. Now in that scenario you think, “Well, can you sell a lot of these products?” Then there’s no difference between working without equity and working with equity. If you could have the exact same employment arrangement in either scenario and you think I can sell as much or more of this startup’s product, then I can have some established companies’ product and whatever, who cares? It’s all the same diff.

Normally what happens is equity is a, it signifies a differential between your market compensation and the compensation you’re willing to take to be a part of this startup venture. So, let’s say that you are, um, that your normal salary range a- again, if you just went down the street to Indeed or, or some other place, you would make $100,000. Um, and you agree to work for, uh, this startup and you’re going to take a salary of $50,000 because that’s all they can afford or whatever the thing is.

Then you could imagine, um, that in your head at least there needs to be a $50,000 differential on the upside that, uh, if things were to go well, that you’re willing to take a risk and everybody here’s taking a risk, but that you would hope to have your incentive, uh, compensation take into account that differential between what you could have gotten out on the open market with an established company with again, maybe Indeed was a bad example but some company where you would have gotten no equity consideration at all. Right?

So, uh, so you can consider that your, your equity or any deferred compensation or any other type of incentive compensation is trying to offset, uh, from the upside. Maybe you’re not always, uh, controlling for the downside like a lot of investors would. But in the event that this thing blows up and becomes huge and it’s an awesome deal then, and, and you’re a part of it for a, four, five years, then you would assume that your equity would be worth that 50,000 times five years or $250,000 or more. Right?

That would be a kind of a logical approach to, uh, how you might structure and then you kind of work, you do the backwards math and you go, “Okay, well then what percentage of the company, uh, would I need to own at what valuation to get in that general ballpark? And then what do we think that companies generally worth now?”

And it’s all just guessing, uh, like ultimately this is a, a lot of kind of, you know, sticking your finger in the, in your mouth and then holding it up to the wind and you, you’re giving it a shot, but you’re at least you have a, you have a methodology for how you got there. And so, so it, it is important to think through that, uh, that incentive or equity-based compensation as, uh, as accounting for the difference between your market compensation and, uh, what you, what you’ve been willing to sacrifice personally in order to be a part of this potential rocket ship.

AUDIENCE           So with the agreement, can that, is that a living document? Can that change during rounds of investment? And if so, who determines the agreement?

BEN                   It does. So you’ll, you’ll, you’ll actually see, if you see agreements, you’ll see amended and restated company agreement. So it is a living document. It will exist in one form, uh, in its earliest stage, and we’ll continue to evolve over time and as more hands are in the cookie jar. More people, uh, and opinions will have a say in that. Ultimately at an end, you know when, when you’re raising money and investors and all that kind of stuff get involved they will review that, that company agreement will be part of the negotiation. That’s actually a huge part of the negotiation between the, the company and in any subsequent investors.

So that actually gets there’s a subscription agreement that is a, a side agreement which is where, “Okay, this is where, um, everybody’s signing that the money is going to here and that sort of thing.” But often as part of that financing there will be a- again maybe an investor says, “I want to have a board seat as a part of this thing.” Well that person’s name, uh, and who they represent will show up on the amended and restated company agreement.

AUDIENCE           Who determines the agreement?

BEN                   The board of directors if that’s, if that’s two people if that’s six people, that’s nine people. They, they have the authority, uh, assuming it’s a typical company agreement again anything, you could say that you’re your pet parakeet determines things in, in a, in a LLC company agreement. And to some extent like, you know, the judge may not like that but that can happen.

AUDIENCE           So distributions, right, or how your investors get paid back. Is that negotiated as part is that when you’re accepting the money or do the board of directors get to do that or is that kind of as it goes?

BEN                   Yes, that’s a great question. So distributions are a way of it, let’s assume that your business actually makes money. Congratulations. And, and, and you’ve even invested all this extra capital into growing your business and yet there is still more money than your distributions are, uh, how you, how you distribute, well, the profits on the upside or the, or the losses on the downside to everyone. Now, when it’s an S Corp. So some of you may be an Scorp. An S Corp is required by law to distribute, uh, anything even if it’s kind of it, it feels like a little bit of an LLC. Distributions can only happen pro-rata in an S Corp. So if you own 43 percent of, of the company then you will get 43% of the profits or losses. End of story.

No, there’s no wiggle room in that, in that. In the case of an LLC there’s tremendous flexibility so you might have an investor who has six other businesses that make a ton of money and they say, “Could I have all the losses of your business please?” And that might be very valuable to them because that all of your losses that you think, “Man that’s a real bummer.” They go, “Yes.” That means that they actually have, uh, less, less taxes to pay. So it’s again this whole tax thing is weird like you’ve got to put on put on your wealthy person hat for a second. You have to think from that perspective you may have an investor or, or even a co-founder who for whatever series of reasons they want losses, losses are good to some people. Uh, they’re actually good to a lot of people but there are also instances where you may have a gain and, and that’s that, that can be equally tricky. Like, you can actually have a scenario where you, you received your portion of a gain and you may or may not necessarily have the money to pay for it.

Again, let- let’s say that you, you own a small percentage of a, a business that, that made a, a million dollars and or le-, again let’s say let’s say it made a million dollars and you own 10% of it. Simple math. So you had $100,000, uh, in, uh, taxable income and you’re like but, but I didn’t actually make any money out of this thing. So now I have to pay taxes on $100,000 that I didn’t actually get any money for. So these are things to consider when you’re structuring your agreement and in your relationships because whatever is in the agreement is how it goes. So there’s tremendous flexibility on the LLC side, less so in some other forms, so.

AUDIENCE           Ah, for seed fund raising, uh, hopefully those will be available until a lot of people here, um, obvious places to go or friends and family, conferences, events. In terms of building on your investor pipeline what are other things you recommend?

BEN                   Yeah, that’s a great question. Couple of quick comments there. If you raise money for your venture from friends and family make sure that you communicate to everyone that they are lighting this money on fire, they will never see it again. Because if you don’t communicate that and they think that they’re genuinely they, they believe that they’re going to get rich off of their investment in you. Every Thanksgiving for the rest of your life will be a living hell. And they’re going to look at you like, “Oh yeah so nice car you drove up in.” Right? Where’s my money? Right, like every, every single thing you ever do it will all come back around so you have to communicate. You have close people in your life, you’re raising money from, maybe, maybe you have a rich uncle an actual rich uncle. And you see that rich uncle every Christmas or some like, just know that if things go bad you’re still going to see your rich uncle and so, rich uncle needs to be of the mindset that I’ve lit the money on fire and if I ever see it again awesome. So, so that’s, that’s one, one thing.

The second thing is I’m a big believer in if possible, your investors should first be super fans. So if you make a product and you do a really good job of sharing it with the world and you, ah, and, and you’re out there on the store shelves and you’re out there at the farmer’s market or whatever else and you’re able to develop a relationship with somebody and that somebody they think, “This is the greatest thing ever. How can I get behind you?”

And that’s for some people they will express that super fandom with, uh, by buying a T-shirt, for some people they happen to have a lot of money and they’ll say, “Can I write you a check?” That’s how, that’s how very wealthy people often express their super fandom. And that’s great for you because what you have done is you have short circuited the analytical side of their brain that- that thinks in terms of Excel spreadsheets and they’re just fan-boying or fan-girling out over your thing and your product. And they say, “How can I be a part of this?” And that’s the best possible investor you could ever have because they’re going to be behind you and they, they want to see it succeed and they want to, they want to help along the way.”

So, uh, you know my, my, my general encouragement is don’t necessarily like air quotes “network” all the time, do really good work and get your stuff out there in the world and you may find investors in unexpected places. I- I can think of, uh, actually several, several folks in, uh, in the Austin ecosystem whose first investors they met at farmer’s markets or at really random like retail scenarios where somebody just like, tried a thing and picked up the package and was like, “This is the greatest thing ever.” And then they like emailed the info at email and said, “Who do I talk to about like being a part of this?” Like, so just make really great stuff that gets people that and that level of infectious enthusiasm and good stuff can come of it.

 

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