Monday, January 16, 2012

Documenting Startup Expenses by Founders

Before a fledgling company is infused with funds from angels or VCs, it typically has to rely on its founders to fund startup expenses and subsequent operations. This is commonly known as bootstrapping. I am often asked about what the proper way is, from a legal perspective, to document these early capital infusions by founders.

First and foremost, founders must keep very good records of company expenses, and never comingle their own funds with the funds of the company. The right way to fund your company in the early days is, as soon as the company has a bank account, to place the funds committed to the venture into the company's bank account and make purchases and payments from that account whenever possible. If a founder does make a purchase on behalf of the corporation on his own credit card, which is what he must do before the company is incorporated and has a bank account, there should be evidence of reimbursement from the company, so that there is no possibility of the corporate veil being pierced.

There are several ways to document initial investment by a founder into his company, and we'll walk through each one:
  1. Purchasing Equity. One way to document a capital infusion into a startup by its founder is by having the founder pay for his equity in cash.

    However, if such purchase is not carefully structured, it can create some awkwardness around the capital structure of the company and the price of common stock. For example, if a founder wants to invest $100,000 and decides to buy 4,000,000 shares of common stock (a good starting number for a solo founder), he is effectively setting the price of common stock at $0.025, which is too high by a factor of... 25x for a very early-stage start-up. Setting the price this high this early may serve as an obstacle to attracting quality employees and consultants. On the other hand, issuing himself 40,000,000 shares at $0.0025 per share is too many shares and isn't appropriate for a company just starting out.

    The other argument against this approach is: no matter how much you invest into your venture at the start, you cannot own more than 100% of it (although you can certainly own less). So if there is another way for you to purchase your shares (such as by using only a small part of the cash infusion for this purpose or by transferring IP to the company), why not provide additional consideration for the money that you, as the founder, invest?

    A note for foreign entrepreneurs: If you hail from a country with which the United States maintains a treaty of commerce and navigation, and you would like to apply for E-2 classification to come to the U.S. on an investor visa, one of the requirements will be to demonstrate a "a substantial amount of capital in a bona fide enterprise in the United States." This investment "must be subject to partial or total loss if the investment fails." In other words, the investment should be made in the form of equity and not debt. In this case, the founder could use the bulk of the investment funds to purchase preferred stock to reflect such founder's investment.

  2. Debt with Repayment. Another way to document startup investment by the founder is by a simple debt instrument, a loan obligation from the company to the founder. This does not provide a lot of upside for the founder on his investment, just the interest. On the other hand, the founder is going to get his upside through his equity stake, which is unrelated to his financial investment. Documenting startup investment by the founder on a promissory note is just a way for the founder to be repaid the money that he invested (with interest) sooner than waiting for the company to achieve a liquidity event. This mechanism can be used whether the founder invested $2,000 or $200,000 thousand into the venture.

  3. Debt with Conversion. Sometimes founders prefer to have their initial investment convert at the time of the first VC round into preferred stock (of the series sold in that round). This especially makes sense for founders who don't need to have a quick return of their investment.

    There are several advantages to holding preferred stock. First, when the company has an exit, there is a possibility, depending on the valuation of the company and the liquidiation preference of preferred stock, that the preferred holders as a group will receive a larger portion of the consideration in the sale than the holders of common stock. In fact, the holders of common stock sometimes receive nothing or next to nothing in a sale, while the preferred holders get their entire or almost entire liquidation preference.

    Holders of preferred stock are entitled to various other rights, such as a right of first refusal on new issuances, antidilution protection, information rights, etc. And preferred shares are not subject to vesting and therefore won't be repurchased if and when the founder leaves the company.

    Lastly, investors like to see founders have some skin in the game. A respectable initial investment by the founder, convertible into preferred stock tells investors that this founder is serious about the venture and is willing to put more than just his time (and personal happiness) on the table.

Happy company-making to all!







