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Startup Economics 101, or, How Long Until We’re Dead? (adgrok.com)
188 points by antongm on Mar 21, 2011 | hide | past | web | favorite | 50 comments

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).

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.

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).

you guys must be Swedes :)

(it sounds smart and well thought out)

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

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 :)

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.

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

It seems like this post could usefully be expanded into a longer article. If you have the time, I would encourage you to write it.

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).

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.

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

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.

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.

no, it's not on the overage. It's on the total amount.

"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."

Lots of cities have payroll taxes, and they're not a "racket" -- it's the cost of doing business in a city. What's unusual about SF is that it has a law that considers gains on employee stock options as taxable pay, not that it has a payroll tax.

well, if we were getting real services from it I wouldn't be as bothered by it.

Yeah. It's a shame we don't get anything like clean water, sewage treatment, police protection, 24/7 fire response, trash pickup, recycling, public transit, street repair or parks in exchange for our taxes.

What a scam.

The SF payroll tax limit is $250,000 now. It changed recently.

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.

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.

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

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.

... which inspired me to hack up a memento mori for my own startup: http://startupdeathclock.com

> 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.

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?

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.

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).

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.

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.

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.

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


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.

"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?

If the dirty hippies had read the paper, they'd see that machinery depreciation is a huge part of that difference between the effective and statutory rates.

The really clever hippies would notice that different industries have different machinery needs.

The especially brilliant ones would understand that the value of an oil lease goes down as the amount of extractable oil goes down, such as happens when said oil is extracted. They'd see that said decrease is just like the expenses of other industries.

Google paid 2.4% last year


"Google’s practices are very similar to those at countless other global companies operating across a wide range of industries," said Jane Penner, a spokeswoman for the Mountain View, California-based company.

http://caps.fool.com/Ticker/GOOG/Statements.aspx?source=icas... shows that Google paid $2.3B on $10.8B pretax income, or 21%. That's far from 2.4%, but it's also far from 35% so I'm a bit lost.

woof... upon closer reading, the headline was misleading. the 2.4% rate is for overseas earnings. "Google’s overall effective tax rate [was] 22.2 percent last year".

it's not hard, however, to find evidence confirming the upstream point that large companies frequently pay a fraction of the 35% rate


Note that Google doesn't pay US taxes on profits that it makes overseas and doesn't bring into the US.

Me - I'd like Google to bring that money into the US but can understand why it isn't willing to pay taxes to do so. Many other countries tax repatriated profits differently, so their companies are more willing to bring said profits back to the mothership.

Well, can we at least agree that the tax code is all kinds of crazy and needs to be reformed, regardless of total revenue take? I thought that was noncontroversial.

Your completely right, the complexity is a much larger threat than the actual amount paid out. Ideally, and this would help immensely, a grace period would include no taxes of any kind paid out for a set amount of time, and no tax complexities to deal with in the set time. We report our numbers on a special tax form and that's it. No tax consultants needed. This would ensure that a larger number of start ups make it to a point where they are large enough to A) hire more people and B)deal with tax complexities without them being a drain on a company's chance of success. If this was possible I would bet that the chances of start ups surviving passed infancy would rise dramatically.

Tax rates do matter. The US has the highest corporate tax rate in the world and you hit the top bracket with ~$2 million in profit (as I remember). That's a large company, but not a huge one.

I'm not saying they don't; Especially on the upside, tax rates matter a lot, and the potential upside effects how much investment a startup gets, at all stages.

I'm just saying, when you are still trying to scramble up to profitability, complex tax laws are a big deal. Certainly under $10K/year profit (and probably for a while further) you are going to be spending more on tax related accounting and planning than you will pay in taxes. You can't just ignore it because you aren't making any money.

It's not just paying the accountant at the end of the year; Especially in lower-margin businesses, how something is taxed can make the difference between profit and loss. You've got to run all your ideas by the tax expert. This is expensive, as both I and the tax expert have deep domain specific experience that needs to be at least partially shared to figure out if a particular idea can work or not.

Yeah, once you've got two million in profit a year, the cost of that tax person is probably a good bit less than what you are paying in taxes, and I imagine you care a lot more about the rate. I'm talking about those of us who are still in the red or only a little in the black.

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

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....?

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?

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..;)

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


According to the IRS (I am a tax attorney/accountant) any officer of a corporation is a "statutory" employee. Anything of value that the corporation gives to that person is construed as wages -- subject to SS tax, medicare tax, federal unemployment, and all the rest of the employee/employer law. (which varies by jurisdiction, but is almost always expensive and onerous). In fact, anything of value that goes to a person related to that officer is wages to the officer. Stock, par or no par, usually has some value. Those are wages.

Just as note to add dark humor to the subject -- note that in the law the employer/employee relationship is called "Master-Servant."

hm. I'm also not a lawyer or a tax professional, so I may have it completely wrong, and I should probably shut up. But my understanding was that if you owned equity in a company and you worked for that company, if the IRS looked at it, in nearly all cases you'd be ruled an employee.

Don't know anyone at the moment, but I've always thought this could be an interesting alternative for a potential founder who has some savings (especially someone roadblocked by a partner search). I haven't heard of many people doing it though, and was curious what the reactions would be.

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