How to Start a Startup: Startup mechanics

Hi, everyone. Thanks for coming in to listen to this. So as Steven said, this lecture is about startup mechanics, which is going to cover some of the the basic issues that most startups will face as they go through the early days of becoming a real company. And I'm really only talking about the basics here. There's a lot of complexity and there's a lot of other things that happen.

But this will kind of give you some ideas of the things you should know about and some of the resources out there that there is to help you with those. I know that we're standing here in California at the moment, but a lot of this stuff will apply to any startups no matter where they are in the world.

And I'll talk a little bit throughout the session about things that are US specific and things that specific to the rest of the world. And this is definitely not the glamorous part of being a startup founder. You'll hear from all sorts of people throughout the rest of this course about all the glamorous things and all the other things.

But these the kind of nuts and bolts that if you take care of in the early days, you stick with the simple, standard, basic processes, you don't try to reinvent new voting structures or anything like that, it will be enough.

On the flip side, if you don't do some of these basics, then the company down the road will come into some problems that will cause a lot of time, effort, and money to get solved. And I'll bring up a few stories as we go through of situations where that's happened. So these are the topics that we're going to cover today. So we're going to kind of go through the life cycle of a company.

So we're going to start in the early days of forming, going through raising some money, hiring some people, giving out shares. Okay, so the first step in this is the formation of the company. And so formation creates a separate legal entity.

And what that means is an entity that will pay its own taxes, be responsible for its own assets, for its own liabilities, sign its own contracts, sue and be sued. And it's all independent of the owners. So you as a founder would be independent of the company. And in The US, this kind of company is called a C Corp, a corporation. There are other structures that are out there for entities to form.

But in the case of startups who are expecting to be successful and to grow and to raise money and to eventually IPO, then a c corp is the way to go. Investors can only really invest in c corps. There's a lot of other things that come in if you decide to go down some other route.

And you may hear some advice from people who aren't necessarily in the startup world to start with a LLC or something like that, which might work in the short term. But then as you become more successful, more in need of raising money, you will have to convert to a c corp. So it probably makes sense if you are thinking about doing a startup in that situation to start with a c corp.

And terminology gets a little bit loose here, and I'm as guilty of this as everyone. But through the whole of this session and when we're generally talking about this, basically the words company, c corp, corporation, entity, startup, all mean the same thing. They all mean this separate legal entity that is a c corp.

All right, the hardest part in formation though is deciding actually when to incorporate this company. Because obviously with a separate legal entity comes a lot of admin and various other processes that have to happen around that. And it's one of those situations where you don't want to do it too soon, but you also don't want to do it too late.

So too soon would probably be if you're still throwing around ideas, you're still thinking about this as a side project, you're not sure if you're going to be doing this for a long time, you don't know if you're going to be working with your co founders. So all of those I would suggest that you don't incorporate at this point.

However, the flip side of that is if you're at the stage where you are creating significant amounts of IP that you want to make sure is clearly owned, particularly if there's more than one of you creating the IP, then that would be a situation where you would want to incorporate.

Another situation is if you've built a product that you're now ready to start charging for, So that you can create a separate entity that takes the money in for the products that you're charging. You want a separate bank account, you want a company bank account and a personal account. You don't want to intermingle those dollars.

And actually, Stripe has a product called Stripe Atlas, which basically helps founders to form a company to the point where they can get a bank account and they can start accepting payments through Stripe. The other reason why you would want to incorporate is just to protect you as individuals.

Because again, as I was saying, a separate entity means that all of the liabilities and anything else that happens there would be on the company rather than you as an individual. So if you get into the situation where that might come important, again, it's a good idea to incorporate.

All right, so at YC, we strongly believe that The US is the best place to incorporate a company, regardless of where the founders come from or where they are when they're actually incorporating. And the reason for this is that the vast majority of the capital that's available to startups is here in The US. And generally, US Investors struggle to invest in non US companies.

There are some exceptions and it is possible, but generally it causes problems. And even for, when you are going through the process of incorporation, you don't actually have to be physically in The US whilst you are incorporating. So then in The US, can incorporate your company in any of the 50 states. You don't have to be, again, be physically located in that state.

You don't have to be planning to do any business in that state. And actually for startups, and for a lot of companies actually, the state that most startups will incorporate in is Delaware. And Delaware, the reason being is that Delaware law is highly developed. Pretty much all lawyers who are working on corporate law in The US know Delaware law. Investors expect to see Delaware companies.

Delaware law allows companies the most flexibility in terms of issuing shares and various other things, and also has the best privacy protections for you as owners. So, it makes a lot of sense to incorporate in Delaware because again, this is one of these situations where there's no point trying to do something different. Just go with the herd on this.

And again, you can incorporate in Delaware as non US citizens. You can incorporate in Delaware when you're not physically in The US. There's no problems there. All right, so let's move on to actually how we incorporate. So, it's a two step process. And so the first part is simply faxing a couple of forms into Delaware to say, I would like to create an entity.

And that takes about twenty four hours for them to process and to get the entity formed. Once that entity has been formed, then the second step in the process is to adopt bylaws for the company, which talk about how the company is going to be governed. Create a board, appoint directors to that board, appoint officers to assign IP to the company.

So you as individuals then start anything you start creating is owned by the company. And also to give out shares in the company, so to assign ownership in the company. The final couple of those, so signing IP and buying shares, I'm going to talk about a little bit more detail. The other three are very legal and complex. So I won't go into those here.

But suffice it to say, there is a couple of different options that you can use to do this. And the first one is to just use a lawyer. A lot of companies will just hire a lawyer to do this. And that's a great option, assuming, especially if you want to do something a little bit non standard in some way or you need some kind of high touch service there.

And it usually costs in the region of $3,000 to $5,000 plus filing fees to incorporate a company with a lawyer. There's loads of lawyers here in the valley, and most of those for startups will actually defer their fees until you raise money. So often those fees can be pushed back and you don't have to pay those immediately.

However, what doesn't work with lawyers is if you have a friend or a cousin who lives in Alabama and is a real estate property lawyer and having them do documents. Because they don't understand how startups work, they don't understand what the standard things are that startup documents include, and so things can go wrong. An example of this is we had a company that came to us in YC that we funded.

And they came to us as a LLC formed in Connecticut. And the reason why they've done that is because the founder's friends who were lawyers in Connecticut told them to do that. And so, when we said we were going to invest, they decided that they were going to convert this at that point to a Delaware C Corp. And they used their Connecticut lawyers to do this, which is great.

However, three funding rounds later, when the company was raising a huge amount of money, a new law firm that they'd hired here in the valley actually discovered that that conversion had been done wrong by the Connecticut lawyers. And therefore, it was not valid. They'd made a very simple mistake, but as a result, it wasn't valid.

And so they had to put the funding round on hold, and they had to sort this out before they could raise the money. It took them six months. It involved four different law firms, and it cost them half a million dollars. So the moral of the story is use Valley Lawyers if you're going to do this and start with a Delaware C Corp.

Another option that's really great, especially for young startups when they're forming is Clerky. Clerky is a YC company. And they have a platform that allows you to create all of these formation documents using a very simple interface where you just plug in a bunch of details and all the forms get populated with those information.

So everything's internally consistent and they allow everything to be e signed on their platform and then they store it all for you. So this is a really great option if you're just going with the basics, you just wanna get it done. It costs a few hundred dollars, again, plus filing fees. So it's a much more straightforward process.

And when we have companies who come to us at YC who we have agreed to fund who haven't been incorporated yet, that's where we send them. We tell them to go and incorporate on Clerky. Okay, so part of the incorporation process then is assigning equity. And this is a really important process because one of the things that happens is it actually creates a conversation between the founders.

It's really important that you do have that discussion amongst the founders to understand how this is going to work. This can often ferret out issues early around, is one founder expecting to work on this part time? Is one founder expecting to work on this full time? It can just try and pull out some issues that might potentially become big problems down the road.

And of course, shares that you own in the company as a founder, if the company is successful, is likely to be the most significant source of wealth creation for you. So it's important that you do actually get this right and that all founders feel it's fair. Fairness is a really important idea here because you're going to be working with your co founders for a long time.

You're to be working in a very stressful environment. And if you have an example, a situation where there's one founder who has 90% of the shares and another founder who has 10% of the shares, but they're both pouring everything they have into this company to make it a success. Resentment can build up. And in a stressful situation, the resentment can bubble up and become worse and worse.

And it's the number one reason that we find co founders break up, because they just can't get to the point where this makes sense to them anymore. And actually, in a lot of these situations as well, when a co founder dispute happens around this, so much effort and time is poured into it that actually the company struggles to survive.

It struggles to turn itself around after the founders have figured this out. One of them has departed and it's all been somewhat acrimonious. So have those conversations upfront. Make sure you understand. Make sure everybody feels it's fair. And in general, we think that equity should be more or less split evenly amongst co founders. And I'm talking about more or less, it doesn't have to be exact.

But often, founders will push back on us on this. And some of the examples that they, or some of the reasons that they will give to us for saying, no, no, I should have 70% of the equity and my co founder should have 30% of the equity. Is because I thought of the idea, or I built the prototype, or I closed the first twenty ks in sales. Or I started three months before my co founder.

And our responses to this is everything is ahead of you. This is the early days of the company. And if you've worked on it for three months, you've probably got five, ten, fifteen years of this company ahead of you if it's going to be a success. So think about forwards, not backwards. All the effort is in front of you. You're going to be iterating on the product.

The prototype is probably going to bear no resemblance to the final product that becomes successful. It's all ahead of you. And the time commitments, again, it's ten years, fifteen years. It's a long time. So three months is just a drop in the ocean.

The only one that maybe is somewhat more of an argument to have slightly more, I'm not talking about significantly more, is you might want to have one co founder who has slightly more shares just to prevent founder deadlock in situations.

But to be honest, if you're at the point where the founders are having to vote their shares to make decisions, then there's probably something more fundamentally broken in the relationship that this is not gonna solve that. So, in conclusion, when you're thinking about allocating equity, think about everything that's ahead of you, not everything that you've just done. So you've discussed it.

You all decide it's fair. You've all got more or less even stock splits. You do actually have to do some paperwork to make this actually happen. And again, this is the kind of thing that can cause problems. Again, company that we invested in came to us already incorporated. They already had all of their shares and everything all set up.

But for various reasons, they actually had to incorporate a new company and merge the old company into the new company. And the shares that they basically swapped their shares in the new company for shares in the old company. Carried on, did well, raised some money, then raised another round of money with, again, new lawyers. New lawyers always go through all the paperwork with a fine tooth coat.

And the new lawyers discovered that actually in the original company, they had never papered the share purchases. So they didn't actually legally own the shares, which meant that then when they swapped them for the new shares in the new company, they didn't own the new shares in the new company because they hadn't actually done a two way transaction.

They hadn't given one thing in return for something else. And so everything they've done since as shareholders were invalid and they didn't have part of the company. So again, queue, lots of lawyers, lots of time, lots of money. And it's just not what needs to be focused on by the company. So the way that you buy your shares as founders is on a stock purchase agreement.

And you, as I say, you exchange it for, usually for cash. So in the case of a formation, you usually pay a few dollars to buy your shares. And the money gets deposited from your individual bank account into the company bank account. Sometimes it's in return for IP, but that gets a little bit more complex. And then once you bought your shares, you have ownership of the company.

And this is how you record the ownership, you use a cap table. Now this is a really basic cap table. It will get more complex as the company goes on. You'll issue shares to employees, you'll issue shares to investors. But basically, the key points of this are that you're recording how many shares each of the people on the cap table owns. So in this case, currently the founders.

And what their ownership is. So in this example, we have three founders. They each have the same number of shares and they each have the same ownership of the company. And we'll come back to this cap table because we're going to build on it as we go through here.

So one of the key parts of the stock purchase agreement that you will sign as founders is that there are actually some restrictions on these shares. So you own them as of the day you buy them. But actually, if a founder was going to leave, then the company has the right to take some of those shares back over time.

And as time progresses, the number of shares that the company has the right to repurchase reduces. And that's called vesting. So to put it the opposite way around, vesting is earning the right to permanent ownership of the shares over time. And here for startups again, it makes sense to use the standard template, the standard process. And generally that is four year vesting with a one year cliff.

And what that means is if you look at this graph over here, we've got time along the bottom and we've got the percentage of your shares that are vested on the y axis. And so the cliff happens at one year. So between day one and day three sixty five, all of your shares are subject to the repurchase option. But then on day three sixty five, 20 five percent of them are immediately released.

So that's where the cliff comes in. Then after that, each month of the year, one forty eight of your shares will vest. So that gradually they're gradually being released. That by the end of the four years, one hundred percent of the shares are vested.

So basically, depending on where you are on the time period of this, if you were to leave the company, you would be able to calculate how many shares you would keep as a founder and how many shares would be repurchased by the company. And the documents are written in such a way that the shares that get repurchased by the company are purchased at the price that was originally paid for them.

So there's no gain or anything built into that. The reason why we have vesting is there's actually a number of different reasons. So the first one is because it provides protection to any remaining founders. So if you think of an example where you're working on a company with three, there's three of you in total, so you and two co founders.

Now let's assume that one of your co founders, and you don't have vesting. Let's assume one of your co founders leaves in six months, but the remaining two founders carry on working on this company, put a huge amount of effort in, build up a successful company over the next five to ten years.

Meanwhile, the ex founder is sitting on a beach drinking cocktails, all these things that people have time to do. How do you feel? You're not gonna feel massively happy that this person has the same amount of value and you're creating all this value for them. And then think about, if your company gets acquired.

Let's say your company is acquired for $500,000,000 Without vesting, that ex co founder would get the same amount of money as the two remaining founders. Which again, is not gonna make you feel that great. So it protects from those situations. If they had been investing and that founder had left after six months, then they would have had no shares in there.

And the remaining founders who put in all the efforts over the next five to ten years would have seen all of the value creation. Somewhat linked to that is the concept of having skin in the game. So this creates an incentive to actually work hard on the company because you need to be there for a long time to actually keep all your shares.

And this is something again that investors care deeply about. Because they don't want to put in a bunch of money into a company when really they're investing in the founders because they're the people who are going to actually make this happen. But the founders turn around after a month and say, yeah, we're out. We're gonna get some new people in to run the company.

So it protects the investors as well. And finally, the final reason is that it sets an example to future employees. And as we'll see in a little while, you would expect employees to have vesting. And so, it's very unfair to say to your employees, you must have vesting, but I don't as a founder. So it's just a good way to be, we all have the same situation here.

Okay, final point on vesting, and this is an important one when you come around to do your paperwork. There is one piece of paper as part of the incorporation process called an eighty three b election. And basically, I'm not going to go into huge amounts of details. But basically, if you don't sign it, then you're taxed on the increase in value of your shares every time your shares vest.

So if you think about that graph, it's after the first year and then every month over the next three years. So this can create huge personal tax liabilities and it also creates company tax liabilities. So this is a bad thing. So the way to solve this is to file your 83 b election. And basically then you don't have this taxation over the vesting period.

It's the one thing in incorporation that cannot be fixed if you don't do it. So you have to file it with the IRS within thirty days. And it's best to retain proof of mailing so that you can actually show that you did that. If you get down the line in a acquisition or when you're doing a funding round, it will get asked for. That proof will get asked for that you signed it.

And we have seen deals fall apart over this, both funding rounds and acquisition deals. Because the investor or the acquirer has been spooked by the potential liabilities on the company, and they just don't wanna go there. And they walk away from the deal. So the way to solve this is follow the instructions.

Either when you're dealing with lawyers or when you're dealing with clergy, they will give you instructions about how to complete the form. They will then give you instructions about where to send it, how to do it. Just follow those instructions and all will be fine. All right, let's move on to fundraising. So you've now got a company that can actually raise some money.

And this is probably something that you'll hear a lot about over the course of the rest of this course. So I'm not going to talk here about the strategy around pricing or valuation or how you talk to investors. I'm talking more about the sort of nuts and bolts that happen behind the scenes.

And in very simple terms, you can either raise money on a priced round or you can raise money on a non priced round, which are also known as convertible rounds. So in a priced round, the shares are sold for a specific price at the time of that round. And in an unpriced or convertible round, the investor gives money now, but the shares are given in the future.

And the ordering for this, usually in The US and usually in the Valley, is that startups will first raise money on a unpriced round. They'll raise a little bit of money. And then a couple of years later, they'll hopefully raise money on a priced round. The rest of the world hasn't quite caught up to this idea of unpriced rounds.

So generally, we see when companies are coming to us from around the world, that they actually raise money immediately on priced rounds. So let's go through an example of a priced round, and you can see how this works. So as I say, the valuation of the round sets the price that the investor will pay to buy a share. So let's work through this with an example.

So let's assume we have the same company as before. Our founders have 9,000,000 shares and they've done really well. And they're gonna raise $2,000,000 at an $8,000,000 valuation. Now that $8,000,000 valuation is pre money, is the terminology. So that basically means before the investor puts any money in, the valuation of the company is 8,000,000.

And so, the way that you calculate the price for the shares that the investor will buy is you just divide the 8,000,000 valuation by the pre money shares. So the 9,000,000 shares, which gives a price of 89¢. And so then they will be able to buy 2,250,000.

00 shares for that $2,000,000 The post money valuation at this point is $10,000,000 because it was the $8,000,000 valuation before the investor put money in. And now there's $2,000,000 sitting in the bank account as well, so it's increased the value of the company up by 2,000,000. So the post money is 10,000,000. And you'll hear those terminologies just to get them straight in your mind.

So now this is what the cap table looks like. So we still have our three founders. They still own 3,000,000 shares each. But we've now created a new class of shares which have been sold to the investor. And now the investor owns 20% of the company. And each of the founders have been reduced from 33% of the company to 26% of the company.

Now this makes it all sound really simple, and actually it's not. There's various other complexities in here that I'm not going to talk about. And there's a lot of documents that are involved in here with a lot of things that need to be negotiated. So if a company is doing a priced round, then you would need to use a lawyer. You'd need to hire a lawyer to help you with all of that.

And they'd be able to talk you through the whole process. So moving on to the unpriced rounds, and for most of companies who raise money now here, out here in the Bay Area, is they will use an instrument called a SAFE, which stands for Simple Agreement for Future Equity. And the simple is really important because it actually is simple. It's only a few pages long, so it's easy to understand.

We also have these documents on the Y Combinator website and a really great primer that explains a lot more about them. So you can look at that for some more details. And basically what it's saying is the investor is giving the company money now in return for the right to receive shares in a future round.

But the investor's giving the money now, and so they don't want to receive shares in a future round at the price of the future round. Because when they invest now, they're probably investing at a much riskier stage, it's a much earlier startup. And so they want some kind of bonus or deal to reflect that. And so the way that that's built in is the SAFE includes what's called a valuation cap.

And what this cap does is it sets a valuation upper bound for the calculation of working out the price for the shares. So again, as an example, we'll use our same company, 9,000,000 shares for the founders. But this time in April of this year, they raised $400,000 on safes with a $4,000,000 cap. And then fast forward some time, we go into the future.

December 2017, they raised a $2,000,000 round, that's an 8,000,000 pre money valuation. So this time, there's actually two calculations that needs to happen. Because there's the safe conversion price and there's the priced round price. And you can see here that the safe conversion price uses the $4,000,000 cap as the valuation, whereas the round price uses the $8,000,000 valuation.

Even though all these shares are being actually given at the same time. And so as a result, the SAFE holder here has a price per share of half the series A investors, the price round investors. So that means that actually for their money, because they came in early, they're getting twice as many shares as somebody who was putting in the same amount of money in the price round.

So that's how they get their sort of bonus in all of this. So again, the cap table, by the time we get to the December priced round, the cap table looks like this. So now we also have the SAFE investor in there on the cap table. And they own the same shares,.

the same class of shares. Yes, question. Does the discount on the SAFE only kick in if the money raised is below the cap?

So, if the dis- so most safes are on a cape, on a cap. There is a separate kind of safe that has a discount. So are you are you asking, does the cap kick in if the the valuation of the round is lower than the cap? So both of those aren't applied in the same safe usually? Generally not. So generally, you wouldn't have a cap and a discount because that's kind of cherry picking for the investor.

So you would try very hard to avoid that situation. In the situation where you had a $4,000,000 cap, but your round was at $3,000,000 for instance, everybody would just convert to the $3,000,000 round. Okay, so, yeah. So again, we have the founders are now earning less of the company because they've sold some of the company to their investors.

Could you talk a little bit about why SAFE is preferred sometimes or what benefits does the SAFE have over.

a price round? Yeah. So the benefits of a SAFE over a price round is that it's a lot simpler. So you can just sign one safe immediately and get the money. It doesn't require lawyers. And I'll come into a few more details. But basically, it's simple and that's the important thing. Okay, so let's talk about dilution and then we'll talk a little bit more about that.

So the idea is, is this at the early stage of your company, if you think about your company as a pie, where the size of the pie is the value of the company. In the early days, you have a massive slice of a very small pie. And then as the company grows, the size of the pie grows, but your slice becomes smaller because you're giving away or you're selling parts of the company.

But the important thing here is that actually your wealth in all of this is the area of your pie, the area of your slice rather. So the thing to bear in mind is that dilution is inevitable, it's going to happen. But the important thing is that you're still creating wealth for yourself and for your investors, because that's how they make money as well.

But it's just very important to actually consider dilution as you're going through. One thing that we see founders make a mistake early on is that they sell too much of the company early on. It's a very low valuation. And really in the early days of a company, you're still trying to figure out what products you're building. You're still trying to figure out what you're going to do.

So what do you need to spend the money on? Well, mostly money when you spend money when you've raised is on hiring. But if you're at that stage, probably don't want to hire. So why raise more money than you need if you can wait six months or a year and raise it to higher valuation? So just something to bear in mind as a way to not sell too much of the company in the early days.

Okay, so in terms of logistics, as I was saying, price round is complex, a safe is simple. Again, with safes, you can use Clerky. They have a fundraising product as well. So they have the standard YC templates built into their system. So you can just plug in the investor details, plug in the amount of money, send it off to your investors to be signed.

They get the bank wire details as well, so they can send the money to the company. Which is also an important point, you do actually want the money back from the investors. It's very easy to say, yeah, we've got investors in, it's great. And our first question is, have you got the money in the bank? And the founders say, oh no, because some excuse.

And we're like, you've got to keep working on your investors until the money is in the bank. The other thing that's a slightly, just a minor point here is that because you're selling equity in the company, the company will need to complete a board consent for part of this, even with a SAFE. And that's a legal document with a specific form.

It's not enough just for the founders to email each other and say, we're doing this right. And again, Clerky will help you with that. Or if you're using lawyers to do any of this, they'll help you with it as well. So it's just something to bear in mind. All right, so now you've raised some money. What are you gonna do with that money? Well, probably you're gonna spend most of that money on hiring.

And again, hiring is a complex area. It's governed by a lot of laws and regulations. And I'm not a specialist, don't expect you as founders to be specialists. The important thing is that you understand the basics and that you understand that there are people out there who can help you with all of this.

Okay, so the first part of this is deciding if you're going to hire somebody, what role they're going to be. So in The US again, you can hire somebody either as a contractor or as an employee. And they have slightly different characteristics and slightly different results in terms of how you pay them. So in both cases, a contractor and an employee will assign the IP that they create to the company.

So a contractor will sign a consulting agreement, an employee will sign an IP assignment agreement. But then for the contractor, there's some requirements for them. So generally, they set their own work hours. They work on a specific project with an end goal that's very defined. They use their own equipment. And they're not really involved in any day to day running of the company.

So an example of this would be you hire a designer to design your website. And it's a month long project and they deliver you a website and you say, great, this is just what we need. And off they go on to their next project. On the other hand, employees will tend to use company equipment. So the company generally will provide them with a laptop.

They will usually be working company hours and in the company location. Course, with startups that gets a little bit gray. There's more supervision. They have less autonomy over their decisions about how they make, how they actually build their or how they do their work. And importantly for The US, for an employee to work in The US, they need to have work authorization.

Whereas a contractor, you could hire to work remotely and they wouldn't need work authorization. So for contractors, if you decide that you are hiring a contractor, then you would agree in the contract how you would actually pay them. And usually that's either time or milestone based.

So milestone based would be, in our example of a web designer, maybe you provide 25% of the fees upfront and you provide the other 75% of the fees when the designer provides the final design for the website. It's really straightforward for the company to pay them because they don't have to worry about any taxes being withheld or anything else like that. So you just pay the contractor.

And then at the end of the year, the company will create a form that's called a form ten ninety nine, which you send to the contractor so that they can include the income in their personal tax returns. And also the company sends one to the IRS. Obviously, that's a US regulation. So if you have a company that's not in The US, then you wouldn't need to file a ten ninety nine.

And generally, if you're working with a contractor who's not in The US, you wouldn't need to file a ten ninety nine either. But things get a little bit more complex there, so take advice. On the flip side, paying employees is more complex for the company.

So the company pays their employees, but they have to withhold, or the company withholds tax on the employee's behalf and pays this over to various agencies. So IRS, to state agencies, and sometimes to city agencies as well. So there's a lot of calculations in there. It gets very complex very fast if you have employees all over in different states. And it's more a headache for the company.

But the IRS prefer it because they get their tax every time the employee gets paid. And then so what happens at the end of the year is the company provides a form W2 to each of the employees. And then the employee uses that to show how much tax has already been withheld on their behalf and how much income they have.

So this is a situation where you should absolutely not be the person calculating all of this. You should use a payroll service provider. It's totally worth the money. It's not very expensive. And they basically take all of this hassle away from you. And the company that a lot of YC startups use, who is a YC company themselves, is Gusto. And they just deal with all of this for you.

It just makes life a lot easier. The other thing to bear in mind is that under California laws in particular, but other laws as well, employees are required to be paid minimum wage. So you can't have somebody working for you for free and expecting them to be producing work for the company. So do just bear in mind that when you are hiring people, you do need to pay them.

The other part of startup employees compensation package is made up of equity. And usually this is again the part that is the way that they possibly create more wealth for themselves. It's really important that startup founders do give employees equity because it helps to incentivize everybody to work towards the same thing, which is creating a successful company.

And often in the early days, for employees, they're being paid below market rate. Still above minimum wage, but below market rate. And so giving them stock in the company is a way to compensate them for that reduction in cash that they're potentially seeing. So it increases their upside. And it's really important that you are generous with shares, particularly in the early days.

Because the people who are going to be employee number one, two, three are going to be with you for a long time. They're going to be working really hard in the same way that the founders are. They're going to be setting how the company goes forward. They're going to be doing a lot of stuff. And so it's important that they are motivated in the same way.

And as a rule of thumb, you can think about giving maybe 10% of the company to the first ten employees. But obviously on a sliding scale. So employee one gets more than employee two who gets more than employee three, etc. And the reason why it's not that much of a gamble to be generous is that all of these will have vesting. All of these employees will have vesting on their shares.

So if something doesn't actually work out and you have to fire the employee, which when you're hiring people, generally startups make a lot of mistakes and have to fire a lot of people. You're not going to be too burnt by that because the vesting means that the company has the right to repurchase their shares.

The way that companies usually structure this is they create a stock plan, which is again another bunch of legal documents which need to be signed and kept. And they, again, can be done on Clerkey or you can use a lawyer to do those for you. And you can either issue shares or you can issue options from that stock plan.

And usually what you tend to find is that employees are issued options, which means that they have the option to pay to buy shares in the future, but the price is set now. And so what this means that's good for the employees is they don't have to pay the cash immediately.

They can actually exercise their options in the future when the company is looking like it's successful, or even in conjunction with an acquisition or something. So they don't even end up anyway in an out of pocket. There are some tax consequences to that, is too much detail to go into now.

But there's a lot of resources online about options, about how to issue options, about the pros and cons of them. So if you're interested, there's lots out there. Finally, the other thing on this is, it's really important to communicate to your employees what they're getting in terms of equity. So first of all, you need to be clear to yourself what they're getting.

Which means that you need to understand the number of shares they're getting and what that represents in terms of percentage of the company. Because if you only give them one and not the other, it gets very confusing. Because you can say, you have x percent of the company, but what does that mean? X percent of what? Whereas if you say, you have 100,000 shares, well, what does that mean?

Is that a lot of the company or is that a small amount of the company? So clear in your head and then be clear with the employee about what's going on. All right, final topic is just a couple of reminders about things that you have to do to be a legitimate company. So it's important that you keep all of these documents that we're talking about in a safe place.

You're going to need them at stressful times. You're going to need them during acquisitions. You're going to need them during fundraising due diligence. You're going to need them so many times that if you don't have them all stored in signed format, it's just going to make your life really hard.

So keep all your documents in a safe place and just assign one of the co founders to be responsible for this. You should make sure you know your key metrics in the company, which again is gonna be covered in a lot of more detail throughout the course. But it's the kind of thing that again you just want to have off the top of your head immediately.

And also, you should make sure that the money that you're spending, that the investors have given to you, is being spent sensibly. Spend money on things that will increase the chances of the company being a success. These investors have trusted you with their money to try to multiply their money.

They haven't given you their money to go off to Vegas, which happened to one of our companies a few years ago. Where one of the founders took quite a lot of company money, went to Vegas, had a great time according to Facebook. And the founders and investors found out and that founder got fired. And actually, he could have faced criminal charges as well.

They decided not to press charges, but just bear in mind that this is the company's money and that's what it should be used for. Okay, so in conclusion, that was a really fast run through of some of the basics. Don't expect you to be experts in any of this. Don't expect you to have all of this figured out. But it's just important that you know that there are some things that you need to do.

And these items up here are sort of the really key takeaways for this to just bear in mind as you go forward with your companies. Okay, I think we have a couple of minutes for questions, if there are any.

For the employee.

shares, what's generous for like the first five employees when you say the word generous?

Well, so it depends because it depends on the kind of hires that you're giving. So if your first hire is going to be a software engineer, that's going to be very different to if your first hire is a community manager, say. I mean, for the first ten is usually somewhere around 10%. Maybe for the first five, you want to be somewhere on the sort of seven, seven to eight mark. But it really varies.

And part of this is you have to think ahead. So you don't want to be giving employee number one you know, 30% of the company and then employee number 20% of the company because you're gonna run out of you're gonna run out of company to give them. So it's it's part of, you know, planning ahead for your hiring needs.

How much transparency should there be inside the company of like the cap table? And how should that change as you grow and improve?

Yeah, mean in the early days where it's just the founders, there should be 100% transparency. Everybody should know everything. Generally, as the company grows, becomes slightly less. You wouldn't show a line by line table to your employees, for instance.

But obviously, this transparency of saying, you have this number of shares and the total number of shares is this, is going to give them the information that they need. Because they only really care about themselves. They don't care. Well, actually that's not true, is it? But they still don't care about themselves. They don't care. They shouldn't care about what the person next to them is getting.

But you wouldn't share that information.

For organizations that may have a faster path to prop profitability and a longer path to exit, is it still sort of best practice to give out equity instead of doing things like profit sharing?

I mean, if it's If you're looking at a a start up, the sort of general start up idea of hockey stick growth and most of the value is created by equity, it's a good idea to to generally compensate people through equity.

If you're looking at more of something that's kind of more of a lifestyle business, which can be a great business for two or three founders who don't take outside money and create a business that's very profitable from the start, then yes, maybe doing some kind of profit share or some kind of very generous bonus scheme or something like that is a better answer.

But usually that's not the case for startups. Usually they're not profitable for a long time.

How do these different things differ if you have more of a non for profit or social good based company that's main targeted isn't necessarily becoming the biggest x.

in some fields? So,.

non profits are very different because there isn't this idea of owning shares and things. So that's a whole different idea. And there's also rules around how much you can pay employees in non profits. On the social good companies, it kinda depends on what sort of a company it is. Again, you need to decide in a way of like what's your mentality. And is your mentality still to be like a startup?

Even though you're going to do some something that gives back, you can still have a startup mentality in that. And so you'd probably still want to go down that path of having equity and having that compensation in that way. And you can still fundraise as well as a social good kind of company. It's a little bit harder, but you can still do it.

So, let's say you granted those 10% of your first ten employees, and then you are going for another round of funding. Do you dilute only co founders or also those.

first employees? No. So, generally, well, this gets a little bit complex. But the simple answer is that subsequent rounds of fundraising will dilute all existing shareholders in proportion to their existing holding. It's a little bit more complex than that, but that's the general. Have to communicate this what you are.

Yes, so you need to make sure that employees will know that you might be giving them shares now that represent 1% of the company. But by the time they get to an exit, it might represent 0. 01% of the company. But in that respect, they probably have been given later, they probably could be given more later on.

And this idea of the pie being much bigger, so even 1% of a company that's worth zero is still worth much less than 0. 1% of a company that's worth $100,000,000.

Just the salient differences between preferred shares and the common shares?

Yes. So investors get preferred shares and as the title suggests, they have some preferences. And I'm not a lawyer, I'm a finance person. So I can do this in a very top level explanation. But basically, have a bunch of rights that common holders don't have. So they have things like liquidation preferences, which means that when the company exits, they're first in line to get their proceeds.

To get the amount of the money that they invested back before anybody else does. So if, for example, if investors invested $2,000,000 into a company and then it got sold, but the cash was. And sorry, they invested $2,000,000 into the company and they own 20%.

But the cash that came out of an exit further down the road was only $2,000,000 They would see all their money before any of the common holders, I. E. The founders, see theirs. So that's one. There's various other different protections that they have in there. That's probably the key one that's the financial basis. But then there's voting rights, there's rights of first refusal.

There's lots of different things. And that's why it's a much more complex negotiation because you have to negotiate all of these rights within there.

Is there any specific company that you see it's really successful on the, like, equity setup? And you don't have to say the company, but like, do you think there's like a specific motto that you think worked really well for companies closed?

That's a great question. I mean, think the companies that do this well are the ones that are transparent. And the ones that sit down with their employees and really talk through what these things mean and what options are and how vesting works. And here's a scenario where some companies will have, if the company exits for this much money, what does this mean to you?

Whereas if the company exits for this much money, how will you see? And so they've calculations and they really make sure that employees understand. And I think that's a really good practice to have. And what that means, or what that needs first, is the founders need to understand it, which is actually surprisingly not common.

Often, I have a lot of conversations with founders where they don't understand this stuff. So they can't even explain it to their employees. So understanding it yourself and being very clear with employees is definitely, and being organized as well.

You said you gave, let's say 10% to the first ten employees. What's like a rough This is all just a rule of thumb. Sure. A rule of thumb. So, Everyone's fixating. My next question, the next rule of thumb is, after dilution, roughly how much of the company do you think on average those first employees would end up owning at an acquisition? I mean, really varies because it depends when.

in the life cycle of the company it gets acquired. It depends how many fundraising rounds there's been. It depends how many more employees have been after them. So there's a lot of different variables there. I mean, the first money that companies raise will be the most dilutive.

So if an employee comes in and there's already been three rounds of money, then they're probably not going to be diluted as much as if they were the first employee in and they have to go through all of that dilution. But it's hard to give a number.

So could you throw some light on how Eduardo Severn's shares in Facebook were diluted?

Oh, no. I don't know any of the details. Sorry.

Do safe notes usually convert to preferred shares or to common equity?

So safes, not safe notes. They convert usually into preference shares. Because again, the investors want all of the rights and privileges that come with those preferred shares. There are some circumstances where they might convert into a combination of preferred and common, but that's less usual.

Have you seen any like different types of vesting schedules for companies that are on like a longer term timeline where the cliff might be longer than a year and the total time might be more than four years?

I sometimes see companies push it out to five years. And also, sometimes companies don't have the cliff at all, and they just do monthly vesting over the period. But that's, it's a harder sell for the five year. The longer the timeline, it's a harder sell for the employees. And so you've got to be mindful of that.

But on the flip side, what usually happens is if you've had an employee who's been with you for four years, then they've been fairly diluted because there's going to have been funding rounds, there's going to have been subsequent employees.

So you would actually give them a new stock grant on top of the one they already have, which would then have new vesting from the date that you granted it from then. So then they'd have another four year period there. So that's kind of how you get along, how you get through the long time period. Okay, last question.

Have you seen any situations where like a founder, like, or a situation where somebody can like trade a common share for a preferred share or the other way around? Or is that common?

So you, there wouldn't really be a case where you would trade common shares for preferred shares. There is a mechanic in the fundraising in the sort of price round documents. This allows preferred shares to be converted into common in various different circumstances. But that's usually around exits and calculation of proceeds and things like that.

Or are you trying to get at like founders preferred shares?

No. I think we just Okay. Okay.

All right. I think we've run out of time. So, thank you very much for listening everyone and enjoy the rest of the course.