
Startup Economics 101, or, How Long Until We’re Dead? - antongm
http://adgrok.com/startup-economics-101/
======
grellas
Be cautious about deferred fees in dealing with lawyers. These have their
legitimate role in the world of startups but, as with any other form of "easy
credit," they can wind up costing you far more in the long run than if you
simply negotiate good rates or fixed fee amounts for work you have at hand.

For example, this piece discusses fee deferrals up to $30K. How would this
work?

A typical deferred-fee deal provides that a startup will get corporate legal
services of up to x amount that are deferred for some fixed time (say, 6
months) or until the company does its first funding at some minimum amount
(say, $1 million), whichever comes first. In exchange, the startup gives the
law firm a small piece of equity for the credit extension. If the startup
fails in its business, the founders are not personally liable for the cost of
the legal services and the law firm eats the loss (this is the credit risk it
takes for which it gets equity in exchange). If the startup does not fail, the
bill comes due in time and must be paid.

Now, a few observations from one who has done such deals many times over from
a lawyer perspective:

1\. The deferred-fee deal is a beautiful fit for the type of go-for-broke,
hope-to-massively-scale company that will depend heavily on VC funding. You
team up with a few co-founders, set your company in motion, and let it fly.
You get heavily diluted up front when the VC funding comes in at $5 million
and up, the burn rate for the company is high, and you go all out with a
prestige team to build that billion dollar company (or at least hundreds of
millions). You hire a law firm that bills $500/hr and up even for green
attorneys and that works in teams. A simple company formation is $5K and up;
your convertible note round is $5K to $10K and up; your Series A round is $50K
to $60K and up. And, if it all works, all this gets paid from VC money. If it
flops, you owe nothing. In a way, then, this is a risk-free way as a founder
to go for broke in launching an ambitious venture.

2\. Now consider a bootstrap venture or an angel-funded venture where the
founders delay outside funding until they can build a credible pre-money
valuation in hopes of minimizing dilution. Unlike the VC-funded case, you will
here want to be much more cautious about what the legal services will cost. In
most such companies, it is easy to get through the first 6 months of the
company's history (a typical deferral period) without coming anywhere close to
spending $30K on a legal budget. Company formation can easily be done in the
$2K-$3K range for the vast majority of such companies; bridge notes for $3K or
so; Series A often for $5K to $10K. Maybe you also need Terms of Service and
other miscellaneous items (e.g., trademark applications). Thus, if you add up
all the typical legal needs of such a venture, you _might_ get up to the $10K
range in the normal case if you spend your money wisely.

3\. The temptation, then, with a deferred-fee deal is to spend on legal
matters with greater abandon given that you are using "easy credit." This made
sense historically under the VC model. It makes less sense under the modern
angel model and even less sense for a company that is going the purely
bootstrap route.

4\. When it comes to deferred-fee deals, then, it is important to count the
real cost. It _may_ be a good step for your company but make sure the fit is
right for your venture. A decade ago, this was a near-ideal arrangement for
most startups with quality founding teams. Today, it makes sense for some but
probably not for most quality startups.

5\. Bottom line: if a deferred-fee deal looks attractive, then, by all means
do it. Just don't treat it as an axiomatic good. Like most easy-credit
arrangements, the ultimate cost to your company (even if not to you
personally) may be quite a bit higher than what it might otherwise be if you
focus purely on the market cost of the services.

I do find it ironic that this item is emphasized in a (nice) piece on watching
your spending and that is what prompted me to comment. Do watch your dollars
and especially when someone offers you something that seems to be all upside
(when it is not).

~~~
antongm
You are absolutely right, and frankly we're wondering if we should do such a
deal right now. I absolutely believe your point that such 'easy credit' will
spur companies to spend more on lawyers than they should. We'd like to avoid
that.

------
kaib
Salaries are hard. We are in a somewhat identical situation, seed funded 6
month old, and were grappling with salaries after we closed our seed round.

We went with something slightly different but probably more appropriate for a
Scandinavian or European country. Basically each founder has a fixed sum that
they can cost the company each month. It's up to each founder to decide how
they split that sum between salary, benefits and mandatory retirement schemes.
The salary itself can vary by as much as 30-40% depending on how you compose
your package.

From my point of view, as the keeper of the cash, this makes burn rate
planning manageable. All of us feel that the system is fair and we also feel
we can optimize it for our own particular lifestyle. As for the actual sums we
agreed on an equal split, with a slightly higher amount for the founder who
had kids (that would be me).

~~~
dotcoma
you guys must be Swedes :)

(it sounds smart and well thought out)

~~~
kaib
Very close, the company is Finnish. That said I'm a Swedish-Finn. :)

~~~
dotcoma
I remember reading a long article it seems I never bookmarked, unfortunately,
on how less likely it would have been for Linux to start and get traction in
any other place, because of the ethos of community and cooperation which
apparently is very strong in Finland (and Scandinavia - never been to Finland,
Italian here :)

------
markklarich
This is my first post on Hacker News. Glad to join you guys and see that
you're talking about finances. I'm an accountant who is also a tax and
business lawyer, specializing in micro businesses and creative projects.
Hopefully I can contribute to the discussion.

This community is full of people who know how to hack code. I'd like to
introduce the idea that it's possible to be equally creative with business
entity design. Business laws and tax codes are just other types of codes,
waiting to be hacked.

Corporations are one way to organize and that structure is well-suited to
mature businesses. But it's far from the best format for beginning creative
enterprises. It seems to be widely accepted that start-ups need to be
corporations to make the transitions smoother as more investors are added down
the line. It's time to reconsider that.

Start-ups have completely different needs than mature businesses and should
not be strangled by all the baggage that comes with a corporation, in the name
of 'making a smoother transition.'

It is fairly simple to start with an organization that is NOT a corporation
and, thereby, avoid payroll taxes. Possibly ALL taxes, depending on the
structure and the source of cash. This is particularly true if you are going
to give equity anyway.

Do some research on entity choice. Examples might be a Limited Liability
Company, Limited Liability Partnership (in some jurisdictions), Limited
Partnership, Limited Liability Limited Partnership (also only in some
jurisdictions), even go naked as as simple Partnership or Joint Venture.

By the time you're big enough to go public, you'll be able to afford the
lawyers you need to reorganize. And that will be the least of your concerns.
In the meantime, pick a business structure that is well-suited to your current
needs, and can even help with some of your current headaches, like salaries,
taxes, and cash flow.

So, yes, a good accountant will pay for themselves many times over. So will a
good lawyer. Finding a good one is the real challenge.

~~~
petercooper
With advice like that, I hope this isn't your last post here too. Welcome to
HN! :-)

------
gaganpalrecha
nice post, unfortunately SF payroll tax is 1.5% over $150,000 in payroll, not
$250k in payroll as mentioned in your article :( It's a racket and is one of
the reasons Twitter and Zynga are threatening to leave SF if the city doesn't
give them a break on the tax. But it hurts the little guys more. If you have 4
employees making $40k each you have to pay 1.5% of 160k, which is $2400 (that
amounts to almost 2 months of office rent or 75% of one employees monthly
salary).

~~~
jbooth
Personally, I'd be willing to take a 1.5% paycut to work in SF instead of the
Valley, because I can't stand suburban commutes. But that kind of reasoning is
probably why I'm in NYC instead of out west to begin with.

EDIT: Also, I'd suspect that the "1.5% on payrolls over 150k" only applies to
the amount in overage, because that's the way most graduated taxes work. So
it'd be 150 bucks on the 10k of overage in your 160k example.

~~~
antongm
Well, in NYC you have a 1.5% income tax, rather than corporate tax, which is
almost worse in a way.

~~~
jbooth
Yeah, and that doesn't even bother me, because I love living here and wouldn't
trade that 1.5% for a suburban commute. To start with, I don't have to own a
car, so that alone probably puts me ahead on income (the cost of rent puts me
right back behind again, though).

I am still upset as a Red Sox fan that a bunch of that money went to
subsidizing the new Yankee Stadium, though.

~~~
gaganpalrecha
but you could move to south san francisco, and have an easy bart commute and
the company wouldn't have to pay any payroll tax.

------
mmaunder
Every dollar you bring in has a significant effect on your runway. While
making a few K a month and making it early may be far from profit, it can
change your runway from 12 months to 18 months and beyond. It can also
determine if you get to call it "my" business or "the" business.

~~~
dstein
It is a tremendous feeling to get to the break-even point and with it the
realization that you can now work on your startup full-time for as long as you
want.

------
lolizbak
A very good post by @asmartbear on the same subject :
<http://blog.asmartbear.com/death-clock.html>

~~~
jacques_chester
I think that the Death Clock article is complementary, rather than an
alternative.

The OP post is essentially a laundry list of expenses that startups can expect
to face. This is useful because it is easy to overlook something that will
blow a hole in your cash.

The Smart Bear post is a higher level look at tools for managing cashflow.
Instead of checking the cashflow balance once per month, you can see almost
immediately what's going on. Short feeback loops are the core of agility.

The only danger I can see with the SB approach is a risk of overcorrecting to
noise. The use of least-squares fitting helps, but mindfulness pays.

------
GBond
> Two blog posts early on (one on NY vs. SF, and another about my time at
> Goldman Sachs) went viral and were what first put us on the map. To this
> day, people stop me when I’m wearing an AdGrok shirt and ask if I’m the guy
> from the blog. We’ve gotten meetings with major companies who might
> otherwise not return emails because of those posts. Pick a fight. Pinch a
> nerve.

It was interesting to know that these blog posts had such a positive effect
just by unearthing a controversy, something out of the 37Signals playbook.
Hard to argue against free marketing despite potentially stepping on a few
toes.

------
Ryujindra
You would think, with the big deal Obama is making about how we need to do
everything we can to encourage more start ups, he would offer some kind of 2
year tax free grace period. I understand that we need to tax to some extant,
but how much more likely do you think start ups would be to succeed if we
didn't have to worry about taxes eating away our already limited money during
the first most crucial steps?

~~~
lsc
Personally, I think that when you are small and not very profitable, lowering
the complexity of taxes would help you more than lowering the tax rate. Most
taxes are on profit (or on income) and nearly all of them are graduated.
Before you are making much money, you don't have to pay out much in taxes.

However, tax complexity makes planning much more difficult. I've gotta include
a tax person in my decision making process. Now, once you are big, this is no
big deal, but as a smaller entity? this is kindof a big deal. And it's another
huge risk factor. If I screw up and end up in massive debit to one of my
vendors or a bank or something, worst case I can declare bankruptcy. If I
screw up my taxes? There is no such escape route available. I know more than
one person who will spend most of their career in debit to the IRS because
they thought they could do their own small business taxes, and screwed it up.

So yeah. for startups? I think complexity of taxes, ultimately, is a bigger
deal than the tax rate. This reverses, I think, as the company becomes more
profitable. Lower tax rates are going to make profitable businesses more
profitable, so lower tax rates would increase the upside for any startup. But
I think that reducing the complexity of the tax code would help those who are
still teetering on the edge of profitability more than reducing the tax rate.

~~~
jbooth
This. The US has one of the highest on-paper corporate tax rates while having
one of the lowest effective corporate tax rates that most companies actually
pay.

This is basically a regressive taxation system for business since small
businesses don't do things like offshore accounts and tax havens, so they get
stuck with the bill. Meanwhile we're incenting big business to spend more time
on that BS than on producing good product. Unfortunately, nobody will be able
to reform this because any amount of moving things around between line items
will be branded as RAISING TAXES!!1one2, even if it's revenue neutral (just
omit the balancing cuts and it's still OBAMA RAISING TAXES).

~~~
jacoblyles
It is hard to get around the 35% US corporate tax rate. In my time as an
investment banker, the only way I saw that companies could easily lower their
taxes is by losing money (losing money one year gives you a carry-forward loss
that you can use to get out of taxes the next, hardly free money). As far as I
am aware, this kind of tax credit is common in the developed world and the US
corporate taxes remain the highest. The impression that you get at reddit/ The
Huffington Post/ Hollywood that you can open up a foreign bank account and
_bam_ no taxes is largely false. All the companies that I sold, capitalized,
or researched paid taxes at close to the nominal rate of 35% (my specialty was
firms $100 million to $1 billion in market cap).

What are your credentials? Perhaps you are a corporate tax accountant and you
know better than I do.

~~~
jbooth
I almost certainly know less about corporate taxes than you do.

But how do you explain the gap between stated and effective tax rate? Maybe
I'm oversimplifying by blaming the Cayman Islands but obviously big
corporations are doing _something_ to pay significantly lower taxes than the
advertised rate.

~~~
jacoblyles
Usually companies with a low effective tax rate have lost money in recent
years. This is especially true over the last 3 years (I believe 3 years is the
limit on a carry-forward loss credit, and 2008-2011 has been bad for
business). The net effect is that US companies pay 35% taxes on their 3-year
trailing average income rather than income in a given year.

Occasionally you will hear another breathless claim on places like reddit/The
Huffington Post/The Daily Kos that some large percent of corporations pay no
corporate taxes at all. They are usually counting the large number of small
businesses organized as S-corps and LLCs which pay pass-through personal
income taxes rather than corporate taxes, and counting all the C-corps that
lost money and therefore paid no corporate taxes for the year. On its face it
is a true statement that most corporations pay no taxes, but it is a very
misleading statement.

In my experience, it is very difficult for the shareholders of a C-corp in the
United States to derive benefit from the entity's business activities without
the benefits being taxed at the corporate level.

~~~
jbooth
Well, so here's a study by the congressional budget office:

<http://cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf>

Puts the effective corporate tax rate a cool 10-15 points under the statutory
one, depending on sector, and has some graphs illustrating that our statutory
rate is one of the highest while our effective rate is one of the lowest.

So it's not just the dirty hippies saying this.

The dirty hippies tend to get angry about stuff like the fact that Exxon
apparently pays little to no corporate taxes (citation needed), and whatever
else they have going on they certainly haven't posted a loss recently.

~~~
jacoblyles
"The dirty hippies tend to get angry about stuff like the fact that Exxon
apparently pays little to no corporate taxes (citation needed), and whatever
else they have going on they certainly haven't posted a loss recently."

Exxon Mobile paid $21 billion in corporate taxes on operating income of $53
billion in the fiscal year ended December 31, 2010 for an effective corporate
tax rate of 40%. Do leftists not know where to look this stuff up? They are
allowed to take finance and accounting classes, no?

------
samratjp
Great writeup! As I read it, it also reminded me of this poem "Dulce Et
Decorum Est" - <http://www.english.emory.edu/LostPoets/Dulce.html>

~~~
Chocobean
Yes, it's quite refreshing to see great literature quotes in a "technical" or
"business" kind of blog post. His reference to Owen's poem is incorrect
though: the phrase originates from one of Horace's Odes, which Owen is quoting
from. In Owen's poem, the phrase was used ironically: it's about as sweet and
proper to die for one's country (or startup) as mustard gas and dead horses
stuck in the mud. Perhaps the irony is intended....?

------
johnrob
What ranges of equity/salary compensation are offered these days? If one
should be skeptical about an employee who wants mostly cash, how should
founders react to someone preferring all equity?

~~~
antongm
I'd be fine with it. I think later on when you've got dozens (or hundreds) of
employees and a limited options pool, it might become unfeasible. But right
now, I'd have no problem with paying an employee only equity. Even tiny
companies like us have valuations that are, well, non-zero, so it's not like
some employee can conspire to get founder equity status by simply not taking
cash.

Why, know someone who will take only equity? Send him/her our way if so..;)

~~~
lsc
Are there legal problems with this? Don't you need to pay at least minimum
wage? Or is that implied?

