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Startup Company Formation Ideas From Peter Thiel

by Saul Fleischman on July 10, 2013

Peter Thiel: founder of PayPal, venture capitalist and author teaches “Startup” at Stanford University.

While reading the detailed notes from the course on the blog of Blake Masters, I am learning what we will soon need to do to make RiteTag scalable, and though to share the following excerpt:

Be a Delaware C-corp.

A very important preliminary question is how you should set up your company.  This isn’t a hard question.  You should set up as a Delaware C corporation.  That is the right answer.  You incorporate to achieve separation of your personal affairs and company affairs.  You want to create a structure where you can let other people in, sell equity, etc. And incorporating can give you a lot more legitimacy.  A business group called “Larry Page and Friends” might work today.  It would not have worked in 1997.   Give yourself the basic structure you’ll need.

There are different kinds of corporations.  None is better for startups than C corporations.  S corporations are good for tightly held businesses.  There can be just one class of shareholders; there is no preferred vs. common stock.  You can’t have stock options.  There are limits to the number of shareholders you can have.  And you can’t go public.  So S corps are only good for companies that won’t scale beyond a certain point.  LLCs are more similar to C corps.  But there can be problems when you want to issue preferred stock, grant options, or go public.  In theory you can get specially drafted agreements to do all these things. In practice it doesn’t work so well.

The big disadvantage for C corps is double taxation.  You pay taxes on corporate income and then personal income too.  Suppose your C corporation earns $100.  The U.S. corporate tax rate is 39.2%.  So $39.20 goes to the government right away.  Now you have $60.80 in net income.  But the U.S. individual income tax is 35% at the highest tier.  That amounts to $21.28.  So you end up with $39.52 if you are a sole proprietor.  LLCs and some other non-C corporate entities are singly taxed entities.  This is why consulting firms and law firms aren’t usually C corporations.

The big advantage of C corps is that exits are easier.  You can take them public.  They are also easier to sell.  Chances are anyone that acquires you will also be a C corporation.  That means that they’re already used to being doubly taxed, and, regardless of your corporate form, they are evaluating your business as if it were already double taxed.  So being an LLC doesn’t make you a more attractive acquisition target.  You might as well just be a C corp.

Over 50% of C corporations get incorporated in Delaware.  There are many reasons for this.  Delaware business law is clear and well-understood.  Its chancery courts are fast and predictable.  The judges are pretty good.  And there’s some signaling too; everybody sort of does it, and most everybody thinks it’s a good thing to do.  You can just take it on faith that you want to be a Delaware C corporation.

Startup Salaries

A categorical rule of thumb that Founders Fund has developed is that no CEO should be paid more than $150k per year.  Experience has shown that there is great predictive power in a venture-backed CEO’s salary: the lower it is, the better the company tends to do.  Empirically, if you could reduce all your diligence to one question, you should ask how much the CEO of a prospective portfolio company draws in salary.  If the answer is more than $150k, do not invest.

The salary issue is important because when CEOs get low salaries, they believe that their equity will be worth a lot and they try to make it happen.  That effect extends to the whole company because capping CEO pay basically means capping everyone’s pay.  You create an equity-focused culture.  Contrast that with the CEO who gets $300k per year.  When something goes wrong in that salary-heavy culture, there is no course correction.  The CEO’s incentive is to keep his well-paying job, not fix things.  If the CEO had a much lower salary, issues would get raised very quickly.  Low pay is simply good incentive alignment.

Vesting and Time

How the equity you give people vests over time is key.  You don’t want to grant it all at once, since then they could just get it and leave.  The standard is to have it vest over 4 years, with 25% vesting at a 1 year cliff, and then with 1/48th vesting each month for the 3 years after that.  This means that if people don’t work out before putting in a whole year, they get no equity.  Often you still give them the fraction they earned, so long as they didn’t cause a bunch of trouble.  But once they’re there a year, they have their 25% and the rest accrues gradually.

Founders need vesting schedules too.  It’s not ideal to have founders who are fully vested from the outset.  One founder might decide to quit.  If he’s fully vested, the co-founder would be stuck working for 2 people.  In practice, things are structured so that part of founders’ equity vests immediately.  They might have 20-25% vest as credit for the work they’ve done up to the first round of financing.  But the rest should vest over time.

Equity

There are several different forms of equity.  There is common stock, which is basically a simple fraction of ownership in a firm.  It is typically expressed in number of shares. But that number itself is meaningless.  Number of shares is just the numerator.  You also need to know the number of shares outstanding, which is the denominator.  Only the percentage of firm ownership matters. 200k/10m is the same as 20m/2bn. 2% is 2%.

A stock option is the right to buy a share of a company’s stock for a set price at some point in the future.  Its exercise price is its purchase price, set at the time the option is granted.  The exercise price is typically set at or greater than FMV at the time of the grant to avoid an immediate tax event; if FMV is $20 and you price an option at $10, the $10 in value that you’re giving is taxable compensation.  Pricing options at FMV ensures that they are worth zero on day one.

Options also have an expiration date, after which they expire.  The idea is that the options become more valuable if the company goes up in value between the grant and the expiration date. If that happens, the option holder gets to buy at the exercise price, and realizes a gain of the FMV at expiration minus that exercise price.  In theory, this is super aligning, since the options could be quite valuable if the company has done well in the interim.

There are two different types of options. Incentive Stock Options, also called ISOs or qualified options, must expire 10 years after being granted or 3 months after employees leave the company. This has the effect of locking employees in.  If they leave, they have to decide whether to exercise soon.  ISOs are also good for individuals because they have favorable tax characteristics. Any option that’s not an ISO is an NSO. With NSOs, all gains up until exercise are treated as ordinary income.

Finally, there is restricted stock, which is basically stock sold to an employee at a very heavy discount.  The company has the right to buy back that stock at the discounted price. It is sort of the mirror image of an option grant in that there is a reverse vest on the restricted stock.  The company has the right to buy less and less back as time goes on.

Equity shares goes down quite a bit as you add more people.  The surest way to blow up a company is to circulate a spreadsheet listing everyone’s equity stake.  Secrecy can be so important here because timing really matters.  Some of your people will have very unique skills. Others will be more commodity employees with fungible skills. B ut the incentives are keyed to when you join, not just what you can do. Key people who arrive later get different stakes than less key people who were early.  At eBay, secretaries might have made 100x what their Stanford MBA bosses because they joined three years earlier.  You can say that’s fair since early employees took more risk.  But the later and possibly more important employees don’t always see it that way. So in practice, even if you calibrate everything correctly, things are imperfect. You won’t be able to please everyone.

Fundraising

Angel investors are the first significant outside investors in a startup.  Ideally they add experience, connections, and credibility.  They need to be accredited, which means a net worth over $1m or an annual income of over $200k.  The angel market is pretty saturated, and the recent passage of the JOBS Act should induce even more angel investing activity.

There are typically two classes of shares: common, which goes to founders and employees, and preferred, which investors investors get.  Preferred shares come with various sorts of rights that allow investors to protect their money.  A standard rule of thumb is that common is price around 10% of preferred in a Series A raise.  If FMV of one share of preferred is $1, a common share would be worth $0.10.

An alternative to this model is to do a convertible debt deal.  There are two standard ways that debt gets structured.  First, you can cap and discount.  This means that valuation is capped, say at $4m.  The noteholder gets a discount of, say, 20% for the next round.  Second, you can do no cap, no discount, and just have warrants/options accumulate for each round.

Convertible notes are often better than equity rounds.  One of the main benefits is that they allow you to avoid determining a valuation for the company.  Angel investors may have no clue how to do valuations.  Convertible notes allow you to postpone the valuation question for Series A investors to tackle.

Other benefits include mathematically eliminating the possibility of having a down round.  This can be a problem where angels systemically overvalue companies, as they might with, say, hot Y Combinator companies.  Additionally, debt loans are much cheaper and faster than equity rounds, which typically cost between $30k and $40k in Silicon Valley.

Series A

After you meet with a VC who wants to invest, you put together a term sheet outlining the deal.  After about a month of final due diligence, where the VC takes a thorough look at the people as well as the financial and technical prospects, the deal closes and money is wired.

You have to set up an option pool for future employees.  5% is a small pool. 15% is a large one.  Larger options pools dilute current shareholders more, but in a sense they can be more honest too.  You may have to give up considerable equity to attract good employees later down the road.  The size of the pool is classic fear vs. greed tradeoff.  If you’re too greedy, you keep more, but it may be worth zero.  If you’re too fearful, you give away too much.  You have to strike the right balance.  Investors want option pools created before a round of financing so they don’t suffer immediate dilution.  You want to make the option pool after you raise.  So this is something you negotiate with your VC.

My four questions for founders of unfunded bootstrapped startups:

venture deals

  1. Do any of my fellow startup bootstrappers find any of this advice hard to integrate in plans for scaling their project up to the next level?
  2. How do you approach the issue of valuation, beyond what you surely learned from Brad Feld and Jason Mendelson’s Venture Deals?
  3. What do you do when you are geographically isolated, are not on the radar of those who could open doors for your project and team – and do not have access to network your way into the good graces of those who can make warm introductions to super-angels and/or venture capital partners?
  4. What are your top online communities or top sources of mentors – for getting actual how-to advice and real support in your quest to go from zero to success with an unfunded bootstrapped startup?
About Saul Fleischman

Founder of emerging social media tool sites. Bootstrapping innovation with lean startup development teams. I do project management, user experience, PR, marketing and community development.

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  • dancristo

    We registered Triberr as an S-corp in Delaware. Why an S-corp? S-corps are very easy to switch over to C-corps (as far as I’ve read). LLC’s are not so easy to convert to a C-corp.

    So as an S-corp we avoid the double taxation that C-corps face while enjoying the easy of converting to a C-corp should we need to have many shareholders in the future.

    That’s interesting about the CEO salary.

  • Mark Fidelman

    The CEO pay is a B.S. figure – Most people in SF and San Jose will find it difficult to live on $150k a year if they own a home and have a few kids. I tend to see Start up CEOs making $190k-$225k in Ca. Less in other States.

    • Saul Fleischman

      Agreed, Mark. Try living with a family in SanFran on 150K, right? What’s more, I just learned that Delaware Corp designations can be changed.

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