The Most Important Questions for Co-Founders

Startups often struggle because of how they are set up.  Too often founders will treat a new company like a budding relationship: you get all excited about your idea, you seem to agree on everything, and then you move in together.  Relationships built on that kind of whirlwind courtship often end up in failure, and startups are no different. It is critically important for co-founders to have the detailed conversations about their business, their working relationship, and many other topics that they will have to deal with as the company grows.  In fact, we have discussed this here on a few occasions (see Founders Series Parts I, II, and III.

One of the people who knows this best is Dharmesh Shah, successful entrepreneur and c0-founder of HubSpot.  He recently published a list of the most important questions that co-founders need to resolve as soon as possible when starting a new business.  If you are in the process of starting a business, stop what you are doing and read it.

This First Thing Every Founder Should Purchase

What is the first thing a new startup company should purchase? Right, a hat rack. Wait, what?  You need one because each founder is going to be wearing several hats - organizationally speaking - and it is important to keep the various roles separate. Here is why. I was recently working with a client who is splitting off from a business he started with a partner, taking some of the assets from their company, and putting those assets into a new company in which he is the sole stockholder. As an exiting founder of the old company and the sole founder of the new one, he is taking on several different responsibilities, including as a stockholder, director, and even lender. This is legally significant, even if he does (inaccurately) refer to "my company" or "my equipment".

But when talking about roles, first understand that that I am not talking about titles. The titles that companies often hand out early on have less to do with the business than they do for establishing some sort of status hierarchy. Some state laws even necessitate designations like president, treasurer, and secretary - Massachusetts is an example - but don't get bogged down in titles. The law dictates legal distinctions between stockholders and directors, but don't try to pigeonhole your team into arbitrary titles that don't fit your organization.  Let the work dictate what roles and responsibilities to assign to management.

Why does this matter, you ask? There are several reasons:

1. Title to property. New founders often erroneously treat company property as personal property. This has ramifications both from a practical standpoint (who owns the property that he wants to take to the next venture) and legal significance (can the company collateralize the property for lenders). If the exiting founder wants to take certain property with him, it is already tied up by a security interest under the company's bank debt? Did the company pay for the equipment or was it using property belonging to its stockholders? Those questions become all the more important when a change of ownership takes place.
2. Organizational confusion. It is critical to sort out the rights and responsibilities of the organization - who has the ultimate control and authority? Often, a pair of founders will split these management roles equally (see my earlier post on why that may not be the best idea), but that effectively means that every decision requires unanimous agreement. Many important decisions have to get made on a daily basis; without proper role assignment, decision-making can get bogged down or actions may be taken without authority or notice. Even worse, an organization may not understand who is responsible for making key decisions.  Not only does this create problems within an organization, but it could also raise red flags to future investors.
3. Legal risk. there are also significant legal ramifications should the rights and responsibilities of the owners and managers get muddled. While state law protects owners from personal liability for corporate obligations, a court may sometimes "pierce the corporate veil" and assign personal liability where owners of a company did not maintain the "separateness" of the entity.  Blurring the lines between corporate and personal increases that risk, as does lax handling of roles. It may seem odd for a stockholder to elect a director who authorizes the company to take debt from a lender when each of those is the same person.  But maintaining those distinct roles will help protect you from liability and confusion.

So where does all of that leave business owners? From the start of your business, choose a structure that fits with your business and keep straight what actions you take as a stockholder versus the actions you take as a director.  Then clearly allocate management responsibilities between the founders and the rest of the team and make sure that structure is clear to the rest of the organization. Because your decisions not only have ramifications for the company, but also may directly impact your personal bottom line.

Trust May Not Be the Best Strategy When Buying or Selling a Business

I have talked before about what makes up a term sheet (also known as a letter of intent) but now we should talk about why it is important.  Any time a business is being sold, the parties - but the buyer in particular - has to incur certain costs in anticipation of the deal, including due diligence costs and certain accounting and (ahem) legal fees.  Before a buyer expends those costs, it wants to have some assurance that they will be well-spent. But that doesn't always happen.  I had a client recently engage with the sellers of a business over the course of a couple of months.  Their on-again, off-again talks had finally started to reach a crescendo toward a deal.  We had begun work on a letter of intent and were ready to send it to the sellers when the email arrived - they sellers had sold to another buyer.

"Can they do that?!?" was the immediate response from my client.  In a word, "yup."  As frustrating as it is, we hadn't yet locked up the deal (even though we were 24 hours away).  It is not always the case with these documents, but they often will have a certain lock-up exclusivity period - with sufficient out clauses for the buyer - so that the buyer can conduct its diligence and do its pre-deal work without the fear of having the deal pulled out from under them.

So as it has been said, "trust but verify" and use your letter of intent to keep you in control of your transaction.

Still Time to Take Advantage of Tax-Free Investment in Small Business Stock

With all of the uncertainty in the markets recently, now is a great time to take another look at one way to create jobs with tax free investment. But you only have a few more months to take advantage of it. Remember the Small Business Jobs Act of 2010?  How about the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011?  Well, if you are a small businesses, a provision of these laws give investors, founders, and other stockholders the right to purchase certain types of small business stock and then sell that stock with tax-free gains of up to $10 million, provided you act quickly and then exercise a little patience.

United States Code Section 1202 was revised to exclude 100% of gains from the sale of "qualified small business stock" and that exclusion counts for both income tax and alternative minimum tax purposes.  But here is some fine print:

• the company must be a C corporation (if you are taking advantage of the flow-through tax treatment of an S corp, you are out of luck);
• the stock must be acquired between September 27, 2010 and January 1, 2012, and must be held for five years before being sold;
• and at least 80% of the assets of the company must be used for one or more qualified businesses.

There are other provisions that may apply to your company as well, so you should review this carefully with your legal and accounting advisors.  But for those companies that meet the conditions, now could be the time to take advantage this temporary opportunity.

Should Massachusetts non-competes be voided?

Non-compete agreements are getting more attention, this time from Scott Kirsner in The Boston Globe today who urges for more common sense:

On a weekend when we celebrate American independence - and all of the blood and sweat that gave us the right to life, liberty, and the pursuit of happiness - I think it’s time for a declaration of a different sort. It is talented, smart, and driven people who make Massachusetts one of the most innovative places on earth. Our residents ought to be able to take their skills where they want and start companies when they want.

I agree with Scott that non-competes can hamper innovation, and have written about their effect. What is telling in Kirsner's article is a quote from an industry trade group about non-competes:

But most business groups oppose significant changes to the status quo. "Our members strongly feel that when they make an investment in an employee, it needs to be protected as it is under current law," says Brad MacDougall, at Associated Industries of Massachusetts, a trade group.

Companies should be more concerned about protecting their own intellectual property than preventing a former employee from taking another job, particularly when that employee gets laid off and is struggling to find work in this economy.  Because at the end of the day, the companies that win should be the ones that innovate better, not the ones who lock up the most people.