The "Nitty Gritty" of Startup Formation

Part 1 in a series in Startup Stages

I'm often asked by first time entrepreneurs what's involved with setting up a business.  Do I need to incorporate?  What do I need to know about hiring?  Payroll?  Do I need a CPA?  How do I register my business?  Why do I need to bother with any of this at all?

The fact of the matter is that for most entrepreneurs non-core activities like filing DE-1 forms and negotiating insurance rates are at best a necessary distraction to the value added tasks of creating product, finding customers, and building a team.  At worst, they can be a confusing labyrinth of rules, regulations, and risks which if ignored or mismanaged can hurt your business.  Unfortunately, business does involve some non-core, administrative overhead that cannot be ignored.  And what you don’t know can bite you.

Compliance with regulatory requirements and contractual terms is a risk-mitigation matter that must be properly managed. While entrepreneurs are often comfortable managing technical and business development risk, they are often less comfortable at managing the legal, financial, and insurance risks.

Poor execution in these areas can hurt a startup’s chance of success in several ways:

• Subject the startup to legal sanctions or other penalties
• Unnecessarily increase overhead cash burn, the lifeblood of a startup
• Jeopardize intellectual property rights
• Impair the startup’s ability to obtain downstream funding
• Cut into an entrepreneur’s most precious resource: TIME!

Large companies can afford the legal, accounting, and other risk management specialists to the degree required (i.e. $$$) to ensure compliance and minimize other risks. But unless you’re a lawyer or CPA or you have an exceptional amount of startup capital, it is unlikely that you’ll be able to do the same.

However with some upfront planning and an understanding of what to look for, it is possible to ensure regulatory compliance and mitigate the largest risks while minimizing cash burn and the impact on your time.

Understanding Risk/Cost Tradeoffs
Using the example of a prototypical technology-based startup in California with eventual plans to seek institutional funding, let's trace its evolution to show how compliance and risk management requirements increase as the business grows.

For most startups, the burden of compliance and risk management increases when the business begins undertaking specific activities that trigger new levels of risk.  The main risk triggers are:

• Formal Organization, “Friends & Family” Funding, and Issuance of Founders’ Shares
• Intellectual Property Creation
• Purchasing by the Business of Products and Services from Third Parties
• Hiring Employees
• Leasing Space
• Accepting Customer Purchase Orders

Let's start by looking at the very first stage leading up to formal organization.

In the beginning....
Prior to the creation and registration of a formal business entity the founding team is informally affiliated, with each person contributing time and money on a voluntary basis and with each individual responsible for his or her own expenses. At some point, as the startup begins to gain momentum and both time and expenses mount, there is usually a desire for the founding team to organize formally so as to limit the founders’ liability to third parties. The founders may also be raising seed capital from “friends and family,” most of whom will be passive investors unfamiliar with the day-to-day activities of the startup.

Formal Organization and Issuance of Founders’ Shares
Corporations and limited liability companies are artificial constructs which serve to limit shareholder and employee liability to third parties. To achieve this, one must comply with the governing laws. In addition to limiting liability, formal organization as a corporation or an LLC defines the following:

• How the economic benefits and risks are to be shared amongst the founders and investors (i.e. shares, share classes)
• How those benefits will be taxed
• The rights and responsibilities of the parties involved
• The compliance requirements to keep the entity in good standing

For startups, the most common business entities chosen are:

• Limited Liability Company (“LLC”)
• IRS Sub-chapter C Corporation (“C-Corp”)
• IRS Sub-chapter S Corporation (“S-Corp”)

The decision as to which business entity to select will have the following implications:

• Tax treatment
• Eligibility for financing from institutional investors
• Administrative burden(least for an LLC, greatest for a C-Corp)

There are tradeoffs associated with the above that need to be considered. While there are a number of “do-it-yourself” books available to help you select and register the proper entity, an attorney is usually the most cost effective way to ensure this is done correctly.

At this stage, assuming there are no employees, compliance requirements are low and involve just a few items:

• Filing Articles of Incorporation or Articles of Organization with Secretary of State
• Board adoption of Bylaws and organizational resolutions (in the case of a corporation) or execution of Operating Agreement (in the case of an LLC)
• Issuance of shares to founders in compliance with Federal and state securities laws
• Securing of a Federal Employer Identification Number (“FEIN”) from the Internal Revenue Service
• Filing a fictitious name statement if the business will be conducted under a name different from the name stated in the Articles of Incorporation or Articles of Organization

Even if there are no employees, an FEIN is usually required by registering agencies and frequently needed for setting up bank and supplier accounts.

Commensurately, ongoing administrative overhead is low, involving:

• Filing annual Statements of Information with the state
• Filing annual Federal and state tax returns
• Basic accounting and record keeping throughout the year adequate to support the tax filings
• Execution of annual written consents reflecting actions of the shareholders and Board, including election of Board members and appointment of officers
• Periodic updating of minute book share registry to reflect stock or option grants

It is advisable to keep the share registry updated, especially as the startup approaches the professional funding stage. There is nothing more frustrating than preparing to close a multimillion dollar funding deal and not being able to get cousin Bobby’s signature because he’s moved to Timbuktu, address unknown.

At some point, the startup may raise funds from “friends and family” or angel investors. As part of the financing process, it will have to make certain representations regarding financial and legal matters. So compliance with these matters will greatly facilitate the financing process, while compliance gaps will complicate it.

Next post:  Implications of Intellectual Property Creation

Switching Costs

A short post today because this weekend, I finally changed over from a six year old IBM Thinkpad T43 laptop to a new Lenovo Thinkpad T410.  No more Windows XP and Microsoft Office 2003.  Yep, now I'm on Windows 7 and Microsoft Office 2010!  Excitement!  Thrills!  Once again, I'm state-of-the-art.  No more having to run out for coffee and bagels while I wait for my laptop to boot up.

So why did I wait so long to change?  Because I hate the switching cost.

I'm not referring to the dollars spent paying for the new hardware.  In fact, I spent less on my new laptop than the unit I'm replacing.  And with all the "free" software and SaaS stuff out there, my software costs are cheaper too.

Rather, what I'm talking about is all the time and effort spent doing the following:

• Migrating files and restoring preferences - In spite of the auto-migration software that comes with the new laptop, this never seems to work right.
• Deleting unwanted pre-loaded software - Mercifully minimal with Lenovo.  See below.
• Re-installing new software
• Re-establishing all the background stuff like Wi-Fi connections, network mappings, and print drivers that I did once before, promptly forgot, but now need to do again to make the laptop useful
• Testing it all out
• Tinkering with the new stuff on the machine that wasn't on my old one - Hey is that a new version of Minesweeper?
• Learning where to find everything now! -  The interfaces for Windows 7 are different from the XP I'm familiar with and Office 2010 is almost a foreign interface from Office 2003. After using the same machine for six years, I had everything fine tuned for maximum ease of use, Ed style.  

It's interesting to see how different companies that rely on regular product upgrades deal with the switching cost issue.

First there's Lenovo.  As most people know, despite the different badges, Lenovo built both my old T43 and my new T410.  Knowing they have a good hardware interface, the tinkering was minimal.  The keyboard layouts are almost identical and the software utility programs are similar and familiar.  And Lenovo whether by design or not, kept the pre-loaded junkware to a minimum.  The result:  minimal distraction and quick ramp up on the hardware.  It was one of the main reasons I decided to stick with the same manufacturer.

Then there's Microsoft.  This is my fifth Office upgrade since I started using it in 1995, and except for the user interface upgrade from 95 to 98, I have yet to derive any benefit from Microsoft moving all the commands and menus around other than to confuse me for the next two months until I finally get back down the learning curve.  Now, while I'm not wasting time waiting for hardware to boot up, I get to waste it looking for where Microsoft stuck the Pivot Table command in Excel 2010!  Yes, I'll eventually adapt, but it made me think twice before springing for MS Office 2010.  I seriously considered making the switch to OpenOffice, the freeware competitive equivalent offered by SUN (now Oracle), but my Early Majority mindset won out...this time.

Something to think about the next time you decide to "improve" your interface.

Process Overkill

I just got off the phone with potential new client, the CEO of a pre-Series A startup.  I feel bad for him because the poor guy just wanted to get his financial accounts in order.  So he hired a well known, reputable accounting firm.  60+ billable hours later, his accounts are still not in order.

Instead, it sounds like a great deal of effort has been expended to automate and integrate his accounting, payroll, banking, and payables systems.  It sounds like the accountants burned through some of the 60+ hours trying to set up ACH electronic transfers between vendors and the company and linking in a SaaS bill pay system instead of just posting entries.

All this for a less than five person, pre-revenue bootstrap startup that probably does less than twenty purchasing transactions a month, most of which are on the company credit card.

Another victim of process overkill.

In a different case, one of my current clients, a thriving $20MM+ revenue business, is just now upgrading from Quickbooks to a conventional ERP system.  As part of the implementation, they are putting in place a formal purchasing process.  The process owner has a common sense approach.  For her, the purpose of the process is to contain costs by reducing redundant buying.  She's scoping the process to facilitate the most common buying situations, not to cover every situation.  She wants the process to be easy for people to use; no massive purchase requisition forms.  And most refreshingly, she knows that she will have to handle exceptions to the process.

Part of startup conventional wisdom in Silicon Valley is that one should build ahead of where you plan to be. Planning to be a $100 million revenue company in three years?  Better get that SAP or Oracle ERP system in place now!

But in my experience, to avoid process overkill, startups would be better off if guided by a different principle:  scale appropriate.

Scale appropriate means working with processes set at the level you are currently at.  Still trying to validate your business model and build prototypes?  You don't need an ERP system.  You don't need elaborately defined purchasing requisition and approval processes.  You don't need ISO9001 level ECO (engineering change order) controls.  And while nice, you don't need your online banking system integrated with your accounting software.  Quickbooks plus a bookkeeper doing manual entries with an occasional account review by a CPA should be suitable for financial tracking.

So how do you determine when it is time to upgrade process and infrastructure?

• Routine tasks are increasingly getting dropped
• Increasing error rate on routine tasks
• High personnel cost associated with the people running the processes (either because you need a lot of people or you need highly trained ones who are really expensive)

Process Implementation Guidelines
So how do you go about implementing scale appropriate processes?  Here are a few of my guidelines:

• Know the Objective - It seems obvious, but before implementing any process, be sure you know what the end goal is.  Is is error reduction?  Workflow simplification?  Scope expansion (i.e. enabling less skilled people to perform the task)?  When you document your process, this should be the first thing at the top of the page!  Why?  Because over time, the purpose for the process will be forgotten and the people who put it into place may be gone.  Soon the process takes on a life of its own and you end up with mindless bureaucracy.  Don't believe it?  During my first turnaround, at an ISO9001 certified company, in forcing a review of every ECO process we had, we discovered one that had never been used in the ten years it had existed, but was driving 25% of the data collection fields for the entire ECO process.  Why had it been implemented?  It was a what/if scenario.
• Set the Metric(s) - Once the objective is set, make sure you have a way of measuring whether the process is being effective  This way, you can determine whether future changes to the process are helpful or harmful.  Frequently, this will help prevent process overkill.
• Evaluate Whether Existing Processes Can Be Pushed Harder - Before implementing a new process, see if the existing processes or infrastructure can be pushed harder.  While I know this is going to go against the advice of every business process person out there, don't fall prey to the "blank paper approach" siren.   This especially goes for evaluating  a new ERP system.  You'd be surprised how hard you can push a legacy ERP system.  And while pushing a legacy system can seem like a lot of useless work, be sure to compare it against the disruption of transitioning to a new system.
• Design for the 80/20 Rule - If you do need a new process, design it to handle the 80% most common work outcomes, not the 20% exceptions.  Designing a process to handle 100% of the contingency situations that might arise is the path to process overkill.  It's usually simpler and more effective to let a person handle the 20% exception cases.  Be very careful listening to the "what if?" person in the room!
• Don't Over Automate/Integrate - While it is tempting to want to automate and integrate all your various processes and systems together for push button convenience, there can be a price to pay as well.  Integration to improve data transmission accuracy or eliminate multiple or complex manual steps that can lead to errors may be worthwhile.  However, the more processes are interlinked, the more you may run into unintended consequences particularly if changes to any of the independent processes are made.  This can lead to a situation where one is spending more time troubleshooting and fixing processes than performing a manual step once in awhile.

One of the biggest sources for process overkill that I see comes when someone attempts to design a process to eliminate a human being.  For all except the simplest processes, this rarely works.  In my mind, it's better to design a process to leverage the capability of a human being, not eliminate them.

Establishing highly integrated and automated processes comes with a price.  Where transaction volume is high, complex in nature, or the consequence of output error is high, it may be worth paying that price.  There is a reason that large multinational corporations, financial institutions, and government agencies tend toward these type of processes.  But they also spend hundreds of millions of dollars with fairly large dedicated IT staffs for the privilege.

For small businesses and startups, the focus should be on effectiveness in getting the job done.  Whether it is done by people, processes, or a combination should be secondary.

Related blog post:  Process vs. "Product" People

Secret to Growth: The Power of No, Part 2

Last week, we told the sad tale of Stone Soup: The Sequel, where Hok failed to exercise the power of no in decision making.  This week, we have our second tale about the constraining power of no....

The Tale of Cinderedna
Once upon a time in 16th century France, there were two cousins, Ella and Edna.  Now as tended to happen back then, a terrible plague ravaged the land.  Ella's mother and both Edna's parents died.  In Ella's case, her father remarried and her story has since become well known.

In Edna's case, being an orphan, she was shuttled from relative to relative until she eventually found a home with a distant uncle, a wealthy merchant.  The merchant and his wife had a daughter about Edna's age named Prosperia.

But the upbringing of the two girls could not have been more different.  While Prosperia lacked for nothing, Edna had little but the clothes upon her back.  But being a resourceful girl, she learned how to do things for others in exchange for things she needed.  She would make deliveries for the local tailor, who in turn, taught her how to sew and provided her with leftover cloth from his workshop.  Where others saw scraps, she saw opportunities.

Whereas Prosperia lived in a beautiful, spacious room, Edna lived in a windowless, converted pantry.  But Edna, being a creative girl, did laundry for a local painter who in turn provided her with pigments and lessons.  Soon her tiny room was brightened up by beautiful murals and designs.

While Prosperia ate only the best and as much of anything she wanted, Edna had to make due with leftovers from the family meal, usually vegetables that Prosperia wouldn't eat in favor of the cakes, pastries, and meats she preferred.  Combined with the fact that Edna worked very hard doing most of the family's cleaning, laundry, and other chores, as Edna got older, she grew into a slender, healthy young woman.

Her cousin, on the other hand, grew fat and soft, catching frequent colds that caused her to miss school often.  (Edna, of course, was not allowed to go to school.)  To compensate, Edna was forced to fetch Prosperia's books and assignments from school and help her cousin with her studies.  Thus Edna taught herself to read and gained an education.

Prosperia had plenty of idle time with which to amuse herself.  And she frittered most of it away on frivolous play. Easily bored, Prosperia tended to drop things when they became difficult, preferring to flit to the next amusement.  Edna, with little free time, learned to set goals, plan ahead, and use her time effectively.  She learned how to persevere when things became difficult, and thus became quite skilled in many things.

Eventually, the two girls grew up.  Edna left home and became a successful dressmaker.  Her designs became legendary and eventually caught the attention of the King of France, who invited her to court.  There she captivated the heart of one of the king's younger sons and eventually married him.  And after a long and happy life, she died at the ripe old age of 96.

Prosperia, on the other hand, never left home.  In spite of the efforts of her parents to introduce her to court, having never cultivated any but the most superficial education, no skills, and only the most trivial interests, her rather dull personality failed to attract any suitors.  Because of her sickly constitution, she eventually caught pneumonia and died at the rather young age of 32.

Constraints force efficiencies and remove potential distractions.  Constraints force decisions to be made.  By forcing choices, constraints foster focus and an understanding of what is core to success.  Constraints are the external no's by which creativity is unleashed in a startup.

Related Posts:
The Power of Yes
Secret to Growth:  The Power of No, Part 1

Secret to Growth: The Power of No, Part 1

In my last post of 2010, The Power of Yes, I talked about the power of yes in the exploratory phase of a venture. The power of yes is the means by which entrepreneurs create something from nothing;  it is the means by which they create a business system which enables the resources of others to be transformed into value that is mutually beneficial to all of the contributors and beyond.

Yet, as a venture moves out of exploration and into growth mode, the power of yes can cripple it.  Instead, a different power, one I call the power of no, must be invoked.

The power of no comes in two flavors.  One is a decision and comes from within.  The other is constraining and comes from without.  To see how these work, I bring you two lesser known sequels to two popular tales.  Today's tale deals with the power of no and decisions.

Stone Soup: The Sequel*
While the story of Stone Soup is well known, what is less known is what happened afterwards. Here is that tale:

Not long afterwards, Hok decided to set off on his own.  Saying goodbye to Lok and Siew, he traveled deeper into the mountains.  After several days, he came across another village, just as war ravaged and frightened of strangers as the last.  Remembering what he had learned from Lok and Siew, he proceeded to the town square where he met a young boy.  Soon, just as before, Hok had a huge pot of water and began to build a fire underneath it.  And just as before, each villager, curious as to how one could make soup out of stones, thought of something that would make the soup even tastier and would run off to fetch it.

As the villagers returned with vegetables, herbs, meat, and all sorts of supplies, three soldiers approached Hok and asked what he was doing.

"Making stone soup," replied Hok.  

"Hmm," said one of the soldiers looking at the food piling up near the pot, "You know that there are dangerous bandits just outside the village that might steal all that has been gathered.  They are probably watching right now.  I'll tell you what, give us something to eat and a share of the soup when it's finished  and we'll guard the square for you and make sure nothing happens."

"That sounds reasonable," agreed Hok.  So the soldiers took some of the food and posted themselves around the square, looking fierce.  And the soldiers having large appetites, periodically helped themselves to the food being prepared for cooking.

Shortly thereafter, Hok was approached by an earnest young man.  "Please sir, we have the makings of a great feast and my brothers and I have been tasked with setting the tables.  The tables would look much nicer with some festive decorations.  We could carve some of the carrots and potatoes into beautiful table sculptures if you would give us some!"

"Of course!" said Hok. And soon the young man and his fourteen brothers were carving basketfuls of carrots and potatoes into beautiful statues of dragons and tigers and fish for laying out on the festively adorned tables.

Next, one of the village merchants approached Hok.  "Young monk, I know where we can get wonderful crabs that would make this stone soup fit for the Emperor's table!  There is a fishing village just fifty miles over the ridge that in exchange for some of our vegetables would sell us these crabs.  I've much experience trading with this village and can guarantee that these crabs are the tastiest in all China.  What do you say?"  Hok thought about it and nodded, and the merchant quickly loaded up most of the vegetables gathered in his cart and set off.

Finally, the water began to boil, and Hok began to add the food to the pot.  Strangely, the pile of food had dwindled to a few carrots, an onion or two, a couple of strands of noodle, and a small piece of beef.  The soup looked much less rich and the aroma wasn't quite as tantalizing as Hok remembered.  "Maybe it just needs to cook longer," he thought.

So Hok cooked the soup for hours.  The sun set as the soup continued to bubble.  The aroma, while thin, was still enough to whet everyone's appetite and soon the grumbling began.

"When is the soup going to be ready?" whined one.

"Doesn't look like much of a soup to me,"  said another.

"I knew the idea of cooking stones was too good to be true,"  grumbled an old man.

"Where is that merchant with the crabs?" wondered an old woman.  "Right now, I'd rather have the vegetables he took cooking in the soup than the promise of crabs that aren't here!"

"Let's add the table decorations to the pot!"  said one child.  "There's plenty there to make a good soup!"

"No!" cried the young man and his brothers,"  Then the table will be dull and lifeless for the feast!"

"What feast fools?" cried the old man.  "The feast is sitting in the bellies of these soldiers guarding against what?  Not only do we not have stone soup, but there is no more food in the village!"

"It's the monk's fault!"  yelled one of the soldiers.  "It was his idea.  He swindled us with his idea that we could make soup out of stones!  Let's stone him!"

With that, Hok leapt up and ran as the villagers began to pelt him with stones.  He ran all night, not stopping until he was back in the safety of the monastery.  Sad and confused, he spent many months pondering what had gone wrong.

It is a well known tenet of strategic planning that strategy is about no, not yes.  Where resources are limited, focus is key to ensuring that they are deployed effectively.  Why the power of no is so important for entrepreneurs is that by nature, entrepreneurs see opportunity everywhere.  While a strength in the startup phase when one is trying to discover and create a business, it can be a liability in the growth phase which is about executing the business model.  By seeing opportunity everywhere, the entrepreneur can fritter away precious resources on possibilities instead of using them to advance the opportunity that has been vetted.

So how does one invoke the power of no?  Here are some tips on that subject.

Stay tuned for next week's tale about the constraining power of no.

* My apologies to Jon J. Muth