Ways to light money on fire
My experiences with entity filings and vesting when building a company
Throughout this month, I’ve received questions from people on how to form their company. Here are my experiences with KinoSol and Nebullam. I hope they help you think about which direction makes the most sense for you and your company.
In 2015 and 1 year into building KinoSol, we won a business plan competition in Minnesota. We had not yet registered as an entity. With a fresh new $35,000 check coming our way, it was time to go through the necessary paperwork. We knew nothing about what entity would be the best. A corporate attorney helping with our filing was part of our prize package in the competition, so we naturally utilized his services for filing.
The attorney pointed out that if we registered as a non-profit, they’d give us the check and that’d be that. If we went with a for-profit entity, it’d have to be a loan and likely have some low interest rate attached to it.
We thought there may be a chance we raised outside capital in the future, and we also thought we could move more quickly by being a for-profit entity. Spoiler alert: we never raised outside capital, and I’m grateful we didn’t go the non-profit route.
Fast forward to the filing. We liked that Minnesota recognized Specific Benefit Corporations (SBCs), which is a fancy way of stating that you put your mission above all else, and the state can hold you accountable to that mission. Iowa didn’t (and still doesn’t) recognize Benefit Corporations, so we became KinoSol SBC, a Minnesota corporation.
Because we didn’t raise outside capital, KinoSol SBC didn’t have to worry about changing entities. No other major problems have popped up, leading us to regret the structure.
That being said, we messed up vesting.
Day 1, the founders made a small contribution to the company to purchase their shares. But we didn’t know anything about vesting schedules. Day 1, all 4 founders were fully vested at 25% each. While it’s nice to have an even starting point, life happens.
At 1 year in, some founders wanted to work full-time, and some founders wanted to work part-time. At 2 years in, some founders wanted to leave the day-to-day, and some founders were working over-time. It was a mess from the cap table perspective. We had to go through issuing new shares at various times, which was a headache for everyone.
Looking back, we should have all completed a Restricted Stock Purchase Agreement on day 1, with a 4-year vesting schedule. All of us would have started equally, and then been rewarded appropriately. Founders A and B leave the company 2 years in, they would have been 50% vested. Their remaining shares would have gone back to KinoSol. No harm, no foul. 4 years into building the company, congrats; you’re fully vested. More on this type of vesting below.
Flash forward to 2017 and registering Nebullam. We knew we’d need to raise capital, but we heard of LLCs in the area raising rounds on convertible notes.
So, Danen and I registered Nebullam as an Iowa LLC for that reason, and because it was the cheapest and easiest at the time.
$500 dollars later, and we had the entity created, an operating agreement, and a buy/sell agreement. Later that year, we’d go onto raise a convertible note round.
In October 2019, we were accepted into Y Combinator’s upcoming Winter 2020 batch. They only invest in Delaware Corporations. Come to find out, most venture funds only invest in Delaware Corporations.
How had no one told us this?
You don’t know what you don’t know, and there are too few startups raising coastal money, from here in Iowa.
Now that we knew we’d have to switch entities, the hunt for pricing was on. We received quotes from as low as $1,500 + the time it took for the bylaws, to $20,000. Quite. The. Range.
We ultimately went with Atrium, because they were offering Y Combinator companies $10,000 in credit, and their attorneys had been there and done that with tech startups who raised venture capital. We’re still with our same attorney today, as he’s gone on to launch his own firm (Mayfield Venture Law).
Throughout the process of transitioning from Iowa LLC to Delaware Corp, while trying to focus in the Y Combinator batch, we had 2 bad experiences that we didn’t see coming.
1. We had an investor who felt like they were losing control by us transitioning to a Delaware Corp. It was a nightmare experience for us, and it ended up costing us a large portion of their check, just to settle the situation (this experience will be its own post at a later time).
2. We had won funding through Iowa Economic Development Authority (IEDA). $125,000, to be exact. The funding was in the form of low interest and royalty agreement loans, to Nebullam LLC. By transitioning into a Corporation, there was to be a tax trigger event. That meant that us founders were going to be on the hook for realizing those gains, and for paying our portion of taxes on those gains. I’ll save the compensation post for another day, but let’s just say we pay ourselves the bare minimum wage to cover bills.
How did we figure it out? Accountants and tax attorneys, at almost $600 per hour. Oof.
Those experiences took an absolute toll on me and my health. Just typing them out has me feeling angry, frustrated, and anxious. But they made me a stronger founder as well.
Thankfully, we made it past those experiences and onto the next stage. Nebullam LLC became Nebullam, Inc. We had a board of directors consisting of the founders, and we took what I believe was a great step in building a long-lasting company. We created an option pool (larger than the industry average 10%), and all founders went to vesting alongside all employees at the same pace. We chose a 4-year vesting schedule (monthly vesting), with a 1-year cliff. That means that at 11 months in, you own 0 shares. At 12 months in, you are 25% vested and own 12/48s your shares. Up front, you purchase your shares through a Restricted Stock Purchase Agreement. I believe this is the best structure for early-stage tech companies. It’s simple. It allows you to aggressively recruit with more upside for more team members. It allows the company to easily purchase any unvested shares when someone leaves the company before their 48 months are up.
Aside: If you’re actively recruiting for your team, Front has an open and free compensation and equity calculator that’s been helpful (Front Equity and Compensation Calculator).
What type of company are you building?
If you’re building a tech company who wants to raise venture capital, you should find a law firm who has that experience. If you’re offered free legal advice, remember that often you get what you pay for. If you set out on the journey with a co-founder, remember that life happens. Making the correct blueprint decisions now can allow your space ship to take off without engine problems later.
And remember to file the 83(b)!