University Startups and Spin-Offs: Guide for Entrepreneurs in Academia (2015)
Part I. Strategies for University Startup Entrepreneurs
Chapter 9. The Legal Setup of Your Startup
Startups are distinct from research projects. They are businesses, not projects. For example, different minimum viable products are projects of your startup: each may have a budget and a deadline. Thinking of your venture this way helps put things into perspective and approach it more professionally.
When you engage people outside the university, they need to perceive your startup as a business. Part of this is having the proper legal setup and financial structure. However, most university startups are never properly incorporated; they put this off until an investor or venture capitalist knocks on the door with an investment proposal. This is a classic catch-22. Startups wait to set up their business structure until they have interest from an investor; but to attract this interest, a professional business structure has to be in place. As long as entrepreneurs see their venture as a project they can abandon anytime, how can they expect serious investors to jump in?
To get out of this feedback loop, the startup’s structure should enter the founders’ minds as soon as they decide to launch their company. Until there is a business entity, the startup does not exist. It is just a research project and an idea.
So far, this book has focused more on the practical aspects of entrepreneurship than the organizational ones. The main goal of the book is to give you an outline of how to move your venture forward and engage others who can help you develop it in the best way possible. Legal proceedings of company foundation, such as agreements between founders and licensing contracts, are discussed at length in the business literature. One thing you cannot ignore, though, is how you set up your startup as a legal entity. You should make the move from a research project to a company as soon as possible after you decide to become an entrepreneur.
This is particularly important if you plan to scale quickly and want to attract joint venture investment or venture capital. If you do not have a proper corporate structure and a corporate bank account, how can a venture capitalist invest in your startup? It will be impossible. Change the way your startup is perceived by yourself and others by professionally incorporating it. Doing so will move you in a new direction when you establish contact with other businesses and investors.
When I speak about the legal setup of your startup, this does not necessarily mean registering a company in your country of residence. Some jurisdictions put up high barriers for new businesses, especially those with high taxes or a shaky court system. There are many ways to gain legal status with an entity incorporated abroad. No investor wants to see their capital eroded by taxes and other fees, so be aware that there may be offshore options to consider. Explaining them here goes beyond the scope of this book. If you feel you need a more complex solution, you should consult a trusted advisor. I only cover basic questions of incorporation in this chapter.
In America, several legal entities to conduct business exist. These occur in similar forms all around the world. I chose the American jurisdiction because it is straightforward to lead the discussion about startup incorporation. The terms for legal entities may be different in your particular country, but at heart, they will be similar. Let’s now look at the most common structures for small and medium enterprises.
This is the simplest legal form a company can take. It is basically a one-person business with a self-employed founder. You may conduct business under your own name, or you can file a DBA (doing business as), which allows you to legally use a fictitious company name. Examples are a web designer, a painter, a tax consultant, and an ice cream stand. There is no distinction between the entrepreneur and the business, so as a sole proprietor you are fully liable for all your actions. If you cause damage through the business, you have to pay from your personal bank account.
Registration and administrative costs are minimal. Outside investment is not straightforward, because a sole proprietorship has no shares to sell. Investments are personal loans to the sole proprietor.
A legal partnership is a sole proprietorship including more than one person. Small ventures are often partnerships. An example would be a group of friends buying a house and fixing it up for resale. Again, there is no distinction between the owners and the business, so they are fully liable with their personal assets.
Registration and administrative costs are minimal. Outsiders cannot readily invest in partnerships. Just as a sole proprietorship, investments are personal loans to the partners. Likewise, a partnership does not sell shares.
Limited Liability Company (LLC)
The LLC is a common form of business in America. It can have one or several owners and can issue shares. In contrast to the sole proprietorship and the partnership, the LLC is considered a separate entity from the owners. There is therefore a firewall between the company’s assets and the owners’ assets. This is great because you as the founder cannot be held responsible for any damages your business or your employees may cause. If the startup incurs any cost that it cannot pay back, then creditors will be unable to sue you personally and repossess your TV and your bicycle.
Registration costs range from a few hundred to a thousand dollars, depending on the state in which you incorporate. The LLC also comes with some administrative costs, but these are small. Investment by outsiders is straightforward: they simply buy shares in the company from the founders. Loans are also possible. All in all, this is the legal setup recommended for startups.
There are several kinds of corporations: S corporation, C corporation, and so on. I will not go into detailed descriptions here. The corporation is one step up from the LLC: you could float this company in the stock market and sell shares to the public in an IPO. Registration is expensive, and so is administration. You also need a unique form of accounting for a corporation, which can be costly. Investing in a corporation is clear-cut and simply involves buying shares from the shareholders. The legal structure of the corporation makes sense for bigger companies. For example, Microsoft and Apple are corporations.
Which Legal Form Should You Choose?
The best form for a startup is often the LLC or a local variation of it. Two things are crucial: ease of investment and clarity about ownership. Because the distribution of shares in the LLC reflects ownership, one glance at the capitalization table explains the whole story.
This discussion about incorporation is nowhere near exhaustive. Find out if the university can hire an attorney who will explain the different legal entities to you in detail and help you select the right one for your purpose. Have an attorney write the incorporation agreements for you. If the university covers this cost, then accept it as a generous gift. If not, then pay the bill yourself. Incorporation is standard legal practice and will seldom cost more than a few hundred dollars. Taking this step makes you a real business. The sooner you address this with your team and the university, the better.
Avoid Ambiguity About Ownership
More than once, I have met with startup entrepreneurs who were months into product development and asked them about their legal structure. A puzzled look appeared on their faces. They believed I was asking about their informal agreements with the university regarding ownership of the product, so they answered something like, “All the founders together own 70% of the invention, university X owns 20%, and professor Y owns 10%.” Did they put this in writing? Of course not. What happens if one founder quits? No idea. What if a venture capitalist wishes to invest? Silence.
Once the discussion about setting up an LLC has begun, confusion about ownership and investment becomes a thing of the past. There can be vesting agreements about shares, so if founders leave before a certain time, their ownership will be reduced, often to zero. If outsiders wish to invest in the company, which involves nothing more than buying shares from the existing shareholders, they can complete the transaction in an afternoon without a headache. Entrepreneurs need to have clarity about possible issues related to their company before they arise. Ownership of the startup and its assets are problem zones that proper legal setup helps clear up.
Make Your Startup Investible as Early as Possible
Here’s another philosophy: money is like water. When you make space for it, that’s where it will flow and accumulate. Put another way, if you make no space for it, money cannot flow to you. You think that is absurd? Bear with me for a minute, and let’s look at an example.
Assume you are currently working on a research project at your university. In your PhD, you study a certain application of Li-ion battery technology. You publish some of your findings and eventually submit your thesis. Would venture capitalists invest in this PhD project? Most likely not, because there is no way for them to do so. Investing in something means buying shares in it or making a loan with interest. The research project has no corporate structure as an independent entity. It is just a line item in your university’s annual budget. Unless your startup is a proper legal entity, it is a research project.
On the other hand, assume you are working on the same PhD, and you have decided to set up a startup based on some of your findings. Your startup exists in form of an LLC, where ownership and share distributions are clear. Now venture capitalists can invest easily. They know what percentage of revenue they will receive, according to the number of shares they buy in your company with their investment. Does this mean a venture capitalist will invest? No, of course not. But the potential for money to flow to you is there. Without the LLC, it is not and never will be.
Never Spend Money to Make Money
You know why rich people have money? Because they keep it and don’t spend it. Duh, you may say. That was my reaction when I heard this piece of timeless wisdom from a neighbor at the age of eight. But three decades later, his words still ring in my ears. What will you do if you find a hundred dollars in the street? Buy fireworks, or lottery tickets for everyone? Or will you save it in the bank at 0.01% interest because you are afraid to be robbed? Whatever your answer, your attitude toward money will largely determine your wealth and the success of your startup.
Most people complain about money and their lack of it. A tennis partner of mine had a film production company. When I asked him how business was, he made a sour face and started off on his usual rant. The shrinking margins in the business. The new kids on the block who lured away his clients. And the new technology that turned everybody and their cousin into filmmakers. Without a miracle, he said, he may have to close shop soon. After our tennis match, we took out our calendars to set up the next one. This would have to wait a few weeks, my friend announced. He would be on another continent, on a golf holiday with his wife. When we walked to the parking garage, I couldn’t help but notice his brand-new Range Rover. Nice toy, eh? Yes, he always wanted the new model XYZ, and because he could trade in his Jaguar, it was a steal. His reasoning for driving luxury cars was that he needed to project an aura of success to his clients—spending money to make money. What attitude toward money does this man have? Not one that is helpful to launch a startup or stay in business when times are rough.
A misconception about launching your own company is that it is expensive. You need to pay your suppliers, buy computers, rent an office, hire staff, pay for expensive advertising and marketing, and so on. Nevertheless, if you are launching your startup straight out of university, none of these costs applies to you. Even if you cannot fall back on an existing infrastructure, you do not need to break the bank. Work out of your house or apartment, attract another founder with skills that complement yours, and launch the company as a team. Test your product in the market before you have it mass-produced. And, of course, lower your own bills as much as possible.
Even though you may not plan to go on a golf holiday or buy a new luxury car, there are still many ways to rein in your monthly bills. Do you really need that data plan that sets you back $50 per month? How about HBO and DirecTV for another $100 per month? Is the old iPhone really not good enough anymore? And do you need to take a taxi to the university for $20 each day when the train only costs $2? With a few simple adjustments, you may be able to save several thousand dollars each year. This can make or break your startup in the early phases. As a startup entrepreneur, get used to bootstrapping with little or nothing as early as possible. Forget about spending money to make money. Even if you have funding, make it a point to use as little as possible and spend only when necessary. Use all the synergies and free infrastructure you can, as long as possible.
The checklist in figure 9-1 sums up what you need to know about moving your startup up a notch.
Figure 9-1. Checklist for a startup’s legal structure