Terminology of Building a Venture Backed Company
The Basics
First you need to familiarize yourself with the basics of the terminology to serve as a foundation for better understanding advanced topics around growing and scaling your company. Without understanding this basic terminology, you will miss key concepts from future exercises.
Company Formation - Types
If you are serious about starting your business, then you will be trying to figure out how to generate revenue. Incorporating a company (creating an entity) will protect you from personal liability from anything that happens to the company or any issues related to customers as you try to grow and generate revenue.
The main types of entity types formed are C-Corp and LLC. Venture backed companies do not often file S-Corporations as they are more suited for small businesses. Benefits of forming a LLC are that they are inexpensive ($120 or even less), have very little paperwork, and very simple taxes. If you take outside investment, you will need to form a C-Corp to handle the issuing of shares properly. However, C-Corps have much more paperwork, more complex tax implications, and are more expensive to file.
If you are looking for outside investment you do not need to already have a C-Corp. When you receive a term sheet from investors you can quickly switch from a LLC to a C-Corp.
For way more detail see below video, but we recommend just forming a LLC on myLLC.com, LegalZoom or any of those inexpensive mainstream organizations to start, and spend your time and money on executing on your business right away while maintaining legal protections.
What is a board of directors?
They can fire the CEO. Also do not put all founders on the Board of Directors, when starting just the CEO should be fine.
Ownership
Equity or stock in a company is the most valuable asset in a startup. You make great personal and financial sacrifices to build your company for many reasons, with one being the financial reward. As many have seen in media, ensuring clear ownership amounts from the very beginning are much easier than negotiating down the road as the company grows and achieves greater success.
Investment
When an investor decides to invest in your company they provide you a document called a Term Sheet. A whole section can be dedicated to just this section, but here are some of the key points where you can dig into more detail. The Term Sheet does describe the terms of the deal, the most important considerations are:
Valuation of the company - how much your company is worth. The agreed upon valuation of your company determines the investors ownership percentage ($ invested/company value = their ownership percentage).
Convertible Notes - this is the industry standard financing instrument for investing in startups. They’re simple, do not require a lawyer, and are standard documentation that protects both parties. It’s hard to determine value of an early stage company so that’s usually negotiated upon between the founders and the investor. Common valuations for companies from first time founders prior to an accelerator is often between $1 million and $3 million. Anything in that range should be fairly in line.
There are several standard templates for Convertible Bonds, they are essentially debt that converts into equity. Make sure to find one of the industry standard notes as those have built-in protections in place for both the founders and investors.
Key attributes to negotiate in convertible notes:
- Liquidation Preference - anything other than 1x is of great concern and you should ask your lawyer.
- Cap - the implied valuation of your company (how much your company is worth)
- Discount - standard at 20%
- Pro rata rights - the investors in this round have the right to invest again at the next round
Vesting
After you agree upon how much equity of the company you will own, you don’t get all your stock right away. You earn that stock over the time, that protects the company in the event a founder leaves early. Vesting schedule is the timeline where you earn the agreed-upon amount of stock you own in the company. For example, if you agree with the founders that you own 8% of the company with a 4-year vesting schedule, then you will earn 2% of the company every year for 4 years.
Cliff - A cliff means that if you do not stay at the company for a minimum amount of time then you forfeit all your stock. The standard term for a cliff is 1-year, meaning if you leave the company before working there one year you will forfeit all your stock. For example, if you have 8% of the company with a 4-year vesting schedule and 1-year cliff, you lose all 8% if you leave in under one year.
