No one likes to talk about it, but the odds of an individual startup making it are pretty daunting. If you want to shift those odds in your favor, one of the most important things to do is to understand where the potential traps are.
1. Choosing the wrong co-founder (s)
This might be tough to stomach, but founders themselves pose the greatest threats to the viability of their startups. This is mainly because of disagreements between founders and premature departures.
When it comes to picking a co-founder choose wisely. Look for someone who will be in it for the long haul. Much like dating, it comes down to alignment on values, compatible approaches to handling ups and downs, and coming up with a back up plan in case things don’t work out.
To avoid a disaster, plan ahead for the possibility of a co-founder leaving. A good way to do this is to have a Founders’ Agreement in place. The process of creating one is an important way to raise issues and set common expectations on things like:
- Roles and responsibilities
- Equity split
- Relative cash contributions
- Time commitment
- What to do if one of you leaves
As part of the agreement, put a vesting plan in place for your equity. Four year vesting with a one year cliff is pretty standard.
2. Playing “Who’s on first?” with intellectual property
Make sure you know who owns yours. It probably sounds obvious, but plenty of startup founders have been surprised to learn that “their” IP was owned by the software developer who just jumped ship, an academic institution one of the cofounders graduated from, or the company one of the founders worked at before she came onboard.
If you haven’t legally assigned the property rights to your company, you don’t own the IP even if your co-founder developed it while working on your business. Read the fine print and make sure you go through the process of getting all IP assigned to the business through a Confidential Information and Invention Assignment Agreement.
A word on NDAs: you can think of this as a public service announcement. Don’t ask VCs to sign them. You should use NDAs and confidentiality agreements with strategic hires. But don’t stop there. Be careful what you disclose. NDAs are difficult to enforce in court. So don’t let the fact that you have a sheaf of signed ones lull you into thinking that you’re not at risk.
Protect your IP: Patents are the gold standard. But applications filings are costly. Expect to pay $20,000-$30,000 for one. But you can file a provisional application that gets your technology on file for a fraction of the cost. You can upgrade to a full application filing later on when you can afford to part with a bit more cash.
3. Dropping the ball on accounting and tax compliance
You can seriously damage your chances of getting funded, not to mention find yourself on the hook for heavy fines and enforcement investigations, if you don’t handle your accounting and tax obligations correctly. Here are some rules of the road to keep you on course:
- Open a business banking account and don’t ever commingle the funds with your personal accounts.
- Separate your business and personal expenses — This is critical for keeping good records both for income tax purposes and for tracking your business’ financial history.
- Keep records of your receipts and invoices — Expensify is a good and easy system to use.
- Understand your tax obligations — Even if you’re not profitable yet and don’t owe taxes, you’re still required to file both federal and state income tax forms. California has a mandatory filing requirement in order for businesses to be “in good standing.” Investors require a certificate showing that your business is “in good standing” as part of their due diligence process.
- Depending where you operate, you might also have municipal filing requirements. And of course you’ll have payroll tax and other obligations. Be very careful who you categorize as an independent contractor. There are huge fines for getting this wrong and many states are aggressively going after violators for payment of back payroll taxes.
- Stay on top of your stock records — The last thing you want is to get into due diligence with a potential investor or acquirer and then have things fall through when you’re unable to produce a coherent record of your equity ownership.
4. Choosing the wrong business structure
Do it right the first time. You can always change your business entity down the road, but it will cost you. There are multiple options and they all have their pros and cons, but if you expect to raise equity, you’ll need to be a Delaware C-Corp. In addition, you have to register as a “foreign corporation” in whichever state or states you do business in.
5. Not playing by the rules when issuing securities
With equity, the best practice is to issue restricted stock (but in Silicon Valley, founder preferred shares are sometimes issued). As the name suggests, restricted stock is subject to vesting over a multi-year period. You must file an 83(B) election with the IRS within 30 days after equity issuance or you could wind up with a hefty tax liability as your stock vests.
If you issue debt (convertible notes are popular in seed rounds in part because they postpone any valuation discussion), you’ll need to file securities registrations with the SEC.
You should raise cash only from accredited investors. But if you do decide to go the friends and family route, make sure that your supporters understand the risks of investing in your startup and also think through the potential damage to your relationship.
There aren’t any guarantees in life, but there are ways to up your chances of startup success with a bit of savvy advance planning.
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