# How to Start a Startup: Startup mechanics

**Author:** Kirsty Nathoo
**Type:** Video
**URL:** https://www.ycombinator.com/library/JR-how-to-start-a-startup-startup-mechanics
**YouTube ID:** 2_IpVq6vKR0

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Kirsty Nathoo is the Managing Director of Finance at Y Combinator. She has worked with thousands of companies through
all stages of their life, from incorporation to hiring to fundraising.

In this lecture, Kirsty covers the basic issues that almost all startups face in their earliest days.

## Transcript

Okay, so before we start,
I wanted to introduce our speaker today. Kirsty Nathoo is the CFO and
a partner at Y Combinator. And she's basically worked virtually with
every company that has gone through YC. So from incorporation to
fundraising to hiring to exits, Kirsty's pretty much seen it all. And today she'll talk to you
about startup mechanics.

>> All right, thank you. Hi, everyone. Thanks for coming in to listen to this. So as Steven said,
this lecture is about startup mechanics, which is going to cover some of the the
basic issues that most startups will face as they go through the early
days of becoming a real company. And I'm really only talking
about the basics here. There's a lot of complexity. And there's a lot of
other things that happen. But this will kind of give you some ideas
of the things you should know about. And some of the resources out there
that there is to help you with those.

I know that we're standing here in
California at the moment, but a lot of this stuff will apply to any startups,
no matter where they are in the world. And I'll talk a little bit throughout
the session about things that are US-specific and things that
are specific to the rest of the world. And this is definitely not the glamorous
part of being a startup founder. You'll hear from all sorts of
people throughout the rest of this course about all the glamorous things and
all the other things.

But these are the kind of nuts and bolts
that, if you take care of in the early days, you stick with the simple,
standard, basic processes, you don't try to reinvent new voting structures or
anything like that, it will be enough. On the flip side,
if you don't do some of these basics, then the company down the road will
come into some problems that will cause a lot of time, effort,
and money to get solved. And I'll bring up a few
stories as we go through,

of situations where that's happened. So these are the topics that
we're going to cover today. So we're going to kind of go through
the life cycle of a company. So we're going to start in
the early days of forming, going through raising some money,
hiring some people, giving out shares. Okay, so the first step in this
is the formation of the company. And so
formation creates a separate legal entity.

And what that means is an entity
that will pay its own taxes, be responsible for its own assets, for its
own liabilities, sign its own contracts. Sue and be sued. And it's all independent of the owners. So you, as a founder,
would be independent of the company. And in the US, this kind of company
is called a C-corp, a corporation. There are other structures that's
out there for entities to form. But in the case of startups
who are expecting to

be successful and to grow and
to raise money, and so, to eventually IPO,
then a C-corp is the way to go. Investors can only really
invest in C-corps. There's a lot of other things that come in
if you decide to go down some other route. And you may hear some advice from people
who aren't necessarily in the startup world to start with a LLC or
something like that, which might work in the short term. But then as you become more successful,

more in need of raising money,
you will have to convert to a C-corp. So it probably makes sense if you
are thinking about doing a startup in that situation, to start with a C-corp. And terminology get's
a little bit loose here. And I'm as guilty of this as everyone. But through the whole of this session, and when we're generally talking about this,
basically the words company, C-corp, corporation, entity,
startup all mean the same thing. They all mean this separate
legal entity that is a C-corp.

All right, the hardest point in formation
though is deciding actually when to incorporate this company. Because obviously, with a separate
legal entity comes a lot of admin and various other processes that
have to happen around that. And it's one of those situations where
you don't want to do it too soon. But you also don't want to do it too late. So too soon would probably be if
you're still throwing around ideas, you're still thinking about
this as a side project. You're not sure if you're going
to be doing this for a long time,

you don't know if you're going to
be working with your cofounders. So all of those, I would suggest,
that you don't Incorporate at this point. However, the flip side of that is, if
you're at the stage where you are creating significant amounts of IP that you
want to make sure is clearly owned, particularly if there's more
than one of you creating the IP, Then that would be a situation where
you would want to incorporate. Another situation is if
you've built a product that you're now ready to start charging for
so that you can create

a separate entity that takes the money in
for the products that you're charging. You want a separate bank account, you want
a company account and a personal account. You don't want to
intermingle those dollars. And actually,
Stripe has a product called Stripe Atlas, which basically helps founders to
form a company to the point where they can get a bank account and they can
start accepting payments through Stripe. The other reason why you would want to
incorporate is just to protect you as

individuals. Because again, as I was saying, a separate
entity means that all of the liabilities, and anything else that happens there, would be on the company rather
than you as an individual. So if you get into the situation where
that might come important, again, it's a good idea to incorporate. All right so, at YC we strongly believe
that the US is the best place to incorporate a company, regardless
of where the founders come from or

where they are when they're
actually incorporating. And the reason for this is that the vast majority of the capital that's
available to startups is here in the US. And, generally, US investors struggle
to invest in non-US companies. There are some exceptions and,
it is possible, but generally it causes problems. And even for, when you are going
through the process of incorporation, you don't actually have to be physically
in the US whilst you are incorporating.

So then in the US, you can incorporate
your company in any of the 50 states. You don't have to, again,
be physically located in that state. You don't have to be planning to
do any business in that state. And actually, for startups, and
for a lot of companies actually, the state that most startups
will incorporate in is Delaware. And the reason being is that
Delaware law is highly developed. Pretty much all lawyers who are working on
corporate law in the US know Delaware law.

Investors expect to see
Delaware companies. Delaware law allows companies the most
flexibility in terms of issuing shares and various other things. And also has the best privacy
protections for you, as owners. So it makes a lot of sense
to incorporate in Delaware. Because, again, this is one of these
situations where there's no point trying to do something different. Just go with the herd on this. And again you can incorporate
in Delaware as non US citizens. You can incorporate in Delaware when
you're not physically in the US.

There's no problems there. All right, so let's move on to
actually how we incorporate. So, it's a two step process, and
so the first part is simply faxing a couple of forms into Delaware to say,
I would like to create an entity. And that takes about 24 hours for
them to process and get the entity formed. Once that entity has been formed,
then the second step in the process is to

adopt bylaws for the company which
talk about how the company's going to be governed, create a board,
appoint directors to that board, appoint officers,
to assign IP to the company so you, as individuals, anything you start
creating is owned by the company and also to give out shares in the company,
so to assign ownership in the company. The final couple of those,
so assigning an IP and

buying shares I'm going to talk
about in a little bit more detail. The other three are very legal and
complex, so I won't go into those here. But suffice it to say there is a couple of different options
that you can use to do this. And the first one is to just use a lawyer. You know, a lot of companies will
just hire a lawyer to do this. And that's a great option, assuming
especially if you want to do something a little bit non standard in some way or
you need some kind of high touch service.

And it usually costs in
the region of $3,000 to $5,000 plus filing fees to incorporate
a company with a lawyer. There's loads of lawyers here in
the valley, and most of those for startups will actually defer
their fees until you raise money. So often those fees can be pushed back,
and you don't have to pay those immediately. However what doesn't work with
lawyers is if you have a friend or a cousin who lives in Alabama and
is a real estate property lawyer and

having them do
the incorporation documents. Because they don't understand how
startups work, they don't understand what the standard things are that
startup documents include and so things can go wrong. An example of this is, we had a company
that came to us in YC that we funded and they came to us as an LLC
formed in Connecticut. And the reason why they'd done
that is because the founders' friends who were lawyers in
Connecticut told them to do that.

And so when we said we were going to
invest they decided that they were going to convert this at that point
to a Delaware C corp and they used their Connecticut lawyers
to do this, which is great. However, three funding rounds later,
when the company was raising a huge amount of money, a new law
firm that they'd hired here in the valley, actually discovered that that
conversion had been done wrong by the Connecticut lawyers, and
therefore it was not valid. They'd made a very simple mistake but
as a result it wasn't valid and so

they had to put the funding
round on hold and had to sort this out before
they could raise the money. It took them six months,
it involved four different law firms and it cost them half a million dollars. So the moral of the story is use valley
lawyers if you're going to do this, and start with a Delaware C corp. Another option that's
really great especially for young start ups when
they're forming is Clerky. Clerky is a YC company and they have
a platform that allows you to create

all of these formation documents using
a very simple interface where you plug in a bunch of details and all the forms get
populated with those information, so everything is internally consistent. And they allow everything to be
e-signed on their platform, and then they store it all for you. So this is a really great option if
you're just going with the basics, you just want to get it done. It costs a few hundred dollars,
again, plus filing fees. So it's a much more
straightforward process. And when we have companies who come to
us at YC who we have agreed to fund who

haven't been incorporated yet,
that's where we send them. We tell them to go and
incorporate on Clerky. Okay, so part of the incorporation
process then is assigning equity. And, this is a really important process,
because one of the things that happens is, it actually creates a conversation
between the founders. It's really important that you do have
that discussion amongst the founders to

understand how this is going to work. This can often ferret
out issues early around, is one founder expecting
to work on this part time? Is one founder expecting
to work on this full time? It can just try and pull out some issues
that might potentially become big problems down the road. And of course, the shares that you
own in the company as a founder, if the company is successful, it's likely to be the most significant
source of wealth creation for you. So it's important that you do
actually get this right and

that all founders feel its fair. Fairness is a really
important idea here because you're going to be working with
your co-founders for a long time. You're going to be working in a very
stressful environment and if you have a situation where there's one founder
who has 90% of the shares and another founder who has 10% of the shares
but they're both pouring everything they have into this company to make it
a success, resentment can build up. And in a stressful situation the
resentment can bubble up and become worse

and worse and it's the number one reason
that we find co-founders break up because they just can't get to the point
where this makes sense to them anymore. And actually in a lot of
these situations as well, when a co-founder dispute happens
around this, so much effort and time is poured into it that actually,
the company struggles to survive. It struggles to turn itself around after
the founders have figured this out. One of them's departed and
it's all been somewhat acrimonious.

So have these conversations upfront. Make sure you understand. Make sure everybody feels it's fair. And in general,
we think that equity should be more or less split evenly amongst co-founders. And I'm talking about more or
less, it doesn't have to be exact. But often,
founders will push back on us on this. And some of the the examples that they or some of the reasons they will
give to us for saying no, no I should have 70% of the equity and my
co-founder should have 30% of the equity, is because I thought of the idea or
I built the prototype or

I closed the first 20k in sales or I
started three months before my co-founder. And our responses to this is
everything is ahead of you. This is the early days of the company and
if you've worked there for three months. You've probably got 5, 10, 15 years of this company ahead of
you if it's going to be a success. So think about forwards not backwards
all the efforts are in front of you. You're going to be iterating on
the products, the prototype is probably

going to bear no resemblance to the final
product that becomes successful. It's all ahead of you and the time
commitments, again, it's 10 years, 15 years. It's a long time, so
three months is just a drop in the ocean. The only one that maybe is
somewhat more of an argument to have slightly more, I'm not talking about
significantly more, is you might want to have one co-founder who has slightly more
shares just to prevent founder deadlock.

In situations. But to be honest, if you're at the point
where the founders are having to vote their shares to make decisions, then there's probably something more
fundamentally broken in the relationship. This is not going to solve that. So in conclusion, when you're
thinking about allocating equity, think about everything that's ahead of
you not everything that you've just done. So you discussed it, you will decide
it's fair, you've all got more or

less even stock splits. You do actually have to do some
paperwork to make this actually happen. And again, this is the kind of
thing that can cause problems. Again, another company that we invested
in came to us already incorporated, they already had all of their shares and
everything all set up. But for various reasons they actually
had to incorporate a new company. And merged the old company
into the new company.

The shares that they got in,
they basically swapped the shares in the new company for
shares in the old company. Carried on, did well, raised some money. Then raised another round of money with,
again, new lawyers. New lawyers always go through all
the paperwork with a fine tooth comb. And the new lawyers discovered this
actually in the original company. They had never papered
the share purchases. So they didn't actually legally own
the shares which meant that then, when they swapped them for
the new shares in the new company.

They didn't own the new
shares in the new company, because they hadn't actually
done a two way transaction. They hadn't given one thing in return for
something else. And so everything they've done
since as shareholders were invalid. And they didn't have part of the company. So again, cue lots of lawyers,
lots of time, lots of money. And it's just not what needs to
be focused on by the company. So the way that you buy your shares as
founders is on a stock purchase agreement.

And as I say,
you exchange it usually for cash. So in the case of a formation, you usually
pay a few dollars to buy your shares. And the money gets deposited from
your individual bank account into the company bank account. Sometimes it's in return for IP, but
that gets a little bit more complex. And then once you've bought your shares,
you have ownership of the company. And this is how you record the ownership. You use a cap table.

Now, this is a really basic cap table. It will get more complex
as the company goes on. You'll issue shares to employees,
you'll issue shares to investors. But basically the key points of this are
that you're recording how many shares each of the people on the cap table are own. So in this case currently the founders,
and what their ownership is. So in this example,
we have three founders. They each have same number of shares, and they each have the same
ownership of the company. I'll come back to this cap table so
get build on it as we get through here.

So one of the, Key parts of the stock
purchase agreement that you will sign is as founders is that there are actually
some restrictions on these shares. So you own them as of
the day you buy them. But actually if a founder was going to leave then the company has the right to
take some of those shares back over time. And as time progresses the number of
shares that the company has the right to repurchase reduces. And that's called vesting.

So to put it in the opposite way around, vesting is earning the right to permanent
ownership of the shares over time. And here for startups, again, it makes sense to use the standard
template, the standard process. And generally, that is four year
vesting with a one year cliff. And what that means is if you look at this
graph over here, we've got time along the bottom and we've got the percentage of
your shares that's invested on the y axis.

And so the cliff happens at 1 year. So between day 1 and day 365, all of your shares are subject
to the repurchase option. But then on day 365,
25% of them are immediately released, so that's where the cliff comes in. Then, after that, each month of the year,
148 of your shares will vest. So that they're gradually
being released so that by the end of the four years,
100% of the shares are vested. So basically, depending on where
you are on the time period of this,

if you were to leave the company, you would be able to calculate how many
shares you would keep as a founder. And how many shares would be
repurchased by the company. And the documents are written in such
a way that the shares that get repurchased by the company are purchased at the price
that was originally paid for them. So there's no gain or
anything built into that. The reason why we have vesting is there's
actually a number of different reasons.

So the first one is because it provides
protection to any remaining founders. So if you think of an example where you
are working on a company where there's three of you in total, so
you and two co-founders. Now let's assume that one of your
co-founders, and you don't have vesting. Let's assume one of your
co-founders leaves in six months. But the remaining two founders carry on
working on this company, put a huge amount of effort in, build up a successful
company over the next five to ten years.

Meanwhile, the ex-founder is sitting
on a beach, drinking cocktails. Doing all these things that
people have time to do. How do you feel? You're not going to feel massively happy
that this person has the same amount of value, and
you're creating all this value for them. And then think about if
your company gets acquired. Let's say your company is acquired for
$500 million. Without vesting,
that ex-cofounder would get the same amount of money as
the two remaining founders.

Which again,
is not going to make you feel that great. So it protects for most situations. If there had been vesting and
that founder had left after six months, then they would have
had no shares in there. And the remaining founders who put in all
the effort over the next five to ten years would have seen all of the value creation. Somewhat linked to that is the concept
of having skin in the game. So this creates an incentive to actually
work hard on the company because you need to be there for a long time
to actually keep all your shares.

And this is something again that
investors care deeply about. Because they don't want to put in a bunch
of money into a company when really they're investing in the founders. Because they're the people who
are going to actually make this happen. But the founders turn around after
a month and say, yeah, we're out. We're going to get some new
people in to run the company. So it protects the investors as well. And finally, the final reason is that
it sets an example to future employees. And as we'll see in a little while, you
would expect employees to having vesting.

And so it's very unfair to say to your
employees you must have vesting, but I don't as a founder. So it suggests a good way to be,
we all have the same situation here. Okay, final point on vesting. And this is an important one when you
come around to do your paperwork. There is one piece of paper as part
of the incorporation process called an 83b election. And basically, I'm not going to go
into a huge amount of details, but

basically if you Don't sign it. Then you're taxed on
the increase in value in your shares every time your shares vest. So if you think about,
that graph is after the past year, and then every month over
the next three years. So this can create huge
personal tax liabilities. And it can also,
it also creates company tax liabilities. So this is a bad thing. So the way to solve this is to
file your 83B election, and

basically then you don't have this
taxation over the vesting period. It’s the one thing in incorporation
that cannot be fixed if you don't do it. So you have to file it with
the IRS within 30 days. And it's best to retain proof of mailing,
so that you can actually
show that you did that. If you get down the line in an acquisition
or when you're doing funding round, it will get asked for, that proof will
get asked for that you signed it. And we have seen deals fall apart
over this, both funding rounds and

acquisition deals, because the investor or
the acquirer has been spooked by the potential liabilities on the company,
and they just don't want to go there. And they walk away from the deal. So the way to solve this,
is follow the instructions, either when you're dealing with lawyers or
when you're dealing with Clerky. They will give you instructions
about how to complete the form. They will give you instructions about
where to send it, how to do it. Just follow those instructions,
and all will be fine.

All right, let's move on to fundraising. So you've now got a company that
can actually raise some money. And this is probably something that you'll hear a lot about over
the course of the rest of this course. So I'm not going to talk here
about the strategy around pricing, or valuation, or
how you talk to investors. I'm talking more about the sort of nuts
and bolts that happen behind the scenes. In very simple terms, you can either raise
money on a priced round, or you can also

raise money on a non-priced round, which
are also known as convertible rounds. So in a priced round,
the shares are sold for a specific price at
the time of that round. And in a non-priced or convertible round,
the investor gives money now, but the shares are given in the future. And the ordering for this,
usually in the US, and usually in the valley is that
startups will first raise money on a unpriced round to raise
a little bit of money. And then a couple of years later, they'll
hopefully raise money on a price strand.

The rest of the world hasn't quite caught
up to this idea of unpriced rounds. So generally, we see when companies
are coming us from around the world, and they actually raise money
immediately on priced rounds. So let's go through an example of a priced
round, and you can see how this works. So other say, the valuation of the rounds sets the price
that the investor will pay to buy a share. So let's work through this,
and with an example.

So let's assume we have
the same companies before. Our founders have 9 million shares,
and they've done really well, and they're going to raise $2 million
at an $8 million valuation. Now, that $8 million valuation
is premoney, is the terminology. So that basically means before
the investor puts any money in, the valuation of the company is 8 million. And so the way that you calculate
the price for the shares that the investor will buy, is you just divide the 8
million valuation by the premoney shares,

so the 9 million shares,
which gives a price of 89 cents. And so then they will be able to buy
2.25 million shares for that $2 million. The post money valuation at
this point is $10 million. Because it was the $8 million valuation
before the investor brought money in, and now this $2 million sitting
in the bank account as well. So it's increased the value of
the company up by 2 million, so the post money is 10 million. And just you'll hear those terminologies
just to get them straight in your mind.

So now,
this is what the cap table looks like. So we still have our three founders,
they still own 3 million shares each. But we've now created
a new class of shares which have been sold to the investor. And now,
the investor owns 20% of the company. Each of the founders have
been reduced from 33% of the company to 26% of the company. Now, this makes it all sound really
simple and actually, it's not.

There's various other complexities in
here that I'm not going to talk about. And there's a lot of documents that
are involved in here with a lot of things that need to be negotiated. So if a company is doing a priced round,
then you would need to use a lawyer, you need to hire
a lawyer to help you with all of that. And they'd be able to talk you
through the whole process. So moving on to the unpriced rounds,
and for most of companies who raised

money now out here in the Bay Area, is
they will use an instrument called a SAFE, which stands for
Simple Agreement for Future Equity. And the simple is really important
because it's actually is simple. It's only a few pages long,
so it's easy to understand. We also have this documents on
the White Combinator websites and really great primer,
this explains a lot more about them. So you can look at that for
some more details. And basically what it's saying is
the investor is giving the company

money now in return for the right to
receive shares in a future round. But the investor's giving the money now,
and so they don't want to receive shares in a future round at
the price of the future round. Because when they invest now, they're
probably investing at a much riskier stage, it's a much earlier startup. And so they want some kind of bonus or
deal to reflect that. And so the way that, that's built in is, the safe includes what's
called an valuation cap. And what this cap does,
is it sets a valuation upper bound for

the calculation of working
out the price for the shares. So again, as an example,
we'll use our same company. 9 million shares for the founders,
but this time in April of this year, they raise $400,000 on SAFEs
with a $4 million cap. And then fast forward some time,
we're going to the future, December 2017, they raise a $2 million round,
that's an 8 million premoney valuation. So this time, there's actually two
calculations that need to happen,

because there's the SAFE conversion price
and there's the priced round price. And you can see here that
the SAFE conversion price uses the $4 million cap as the valuation. Whereas, the round price uses
the $8 million valuation, even though all these shares are being
actually given at the same time. And so as a result,
the SAFE holder here has a price per share of half the series A investors,
the price round investors.

So that means that actually for
their money, because they came in early,
they're getting twice as many shares as somebody who was putting in the same
amount of money in the priced round. So that's how they get their
sort of bonus in all of this. So again, the cap table, by the time
we get to the December priced round, the cap table looks like this. So now, we also have the SAFE Investor
in there on the cap table. And they own the same class of shares. Yes, question.

>> Does a discount on the SAFE only kick
in if the money raised is below the cap? >> So most SAFEs are on a cap. There is a separate kind of
safe that has a discount. So are you asking does the cap kick in if the valuation of the round
is lower than the cap? >> So both of those aren't
applied in the same safe usually? >> Generally not. So generally you wouldn't have a cap and a discount because that's kind of
cherry picking for the investor.

So you would try very hard
to avoid that situation. In the situation where you had a $4
million cap, but your round was at $3 million for instance, everybody would
just convert to the $3 million route. Okay, so
again we have the founders are now owning less of the company because
they've sold some of the company to their investors
>> Could you talk a little bit about

why safe is preferred sometimes
sort of 10% [INAUDIBLE]. >> Yes, so
the benefits of a safe over priced round is that it's a lot simpler, so
you can just sign one safe immediately and get the money, it doesn't require lawyers
>> And I'll come and do a few more details. But basically it's simple. And that's the important thing. Okay, so let's talk about dilution and then we'll talk a little
bit more about that. So the idea is this is the early
stage of your company.

If you think about your company as a pie. Where the size of the pie is
the value of the company. In the early days, you have
a massive slice of a very small pie. And then as the company grows,
the size of the pie grows but your slice becomes smaller. Because you're giving away or
you're selling parts of the company. But the important thing here is
that actually your wealth and all of this is the area of your pie,
the area of your slice rather. So the thing to bear in mind is
that dilution is inevitable.

It's going to happen. But the important thing is is that you're
still creating wealth for yourself and for your investors, because that's
how they make money as well. But it's just very important to actually
consider dilution as your going through. One thing that we see founders
make mistake early on is that they sell too much of the company
early on to very low valuation. And really in the early days of a company, you're still trying to figure out
what products you're building. You're still trying to figure
out what you're going to do.

So what do you need to spend the money on? Well, mostly money when you spend you
money when you've raised is on hiring. But if you're at that stage,
you probably don't want to hire. So why raise more money than you
need if you can wait six months or a year, and rate at a higher valuation. So just something to bear in mind, as a way to not sell too much of
the company in the early days. Okay, so in terms of the logistics as
I was saying, price round is complex, as SAFE is simple.

Again, with SAFEs you can use Clerky. They have a fundraising product as well,
so they have the standard YC
templates built into their system. So you can just plug in the investor
details, plug in the amount of money, send it off to your investor to be signed, they get the bank wire details as well so
they can send the money to the company. Which is also an important point
you do actually want the money back from the investors. Is very easy to say, we've got investors
in and it's great our first question is.

Have you got the money in the bank and
to fund the sale, no because some excuse, you got to keep working on your investors
until the money is in the bank. The other thing that's a slightly,
just a minor point here. Is because,
you're selling equity in the company. The company, will need to complete a board
consent for part of this even with a safe. And, that's a legal document
with a specific form. And it's not enough just for the founders
to [INAUDIBLE] each other and say, we're doing this right.

And again Clerky will
help you with that or if you're using lawyers to do any
of this they'll with it as well. So it's just something to bear in mind. All right, so
now you've raised some money, what are you going to do with that money? Well probably you're going to spend
most of that money on hiring. And again, hiring is a complex area. It's governed by a lot of laws and
regulations. And I'm no specialist. Don't expect you as
founders to be specialists.

The important thing is that you understand
the basics and that you understand that there are people out there who
could help you with all of this. Okay, so the first part of this is
deciding if you're going to hire somebody, what role they're going to be. So in the US, again, you can hire somebody
either as a contractor or as an employee. And they have slightly
different characteristics and slightly different results in
terms of how you pay them. So in both places, a contractor and

an employee will assign the IP
that they create to the company. So a contractor will sign
a consulting agreement, an employee will sign an IP
assignment agreement. But then for the contractor,
there's some requirement for them. So generally, they set their own
work hours, they work on a specific project with an end goal that's very
defined, they use their own equipment and they're not really involved in any
day to day running of the company.

So an example of this would be, you
hire a designer to design your website, and it's a month long project and
they deliver you a website. And you say great this
is just what we need. And off they go onto their next project. On the other hand, employees will be
tend to use company equipment, so the company generally will
provide them with a laptop. They will usually be working company
hours and in and the company location. Of course,
with startups that gets a little bit gray.

There's more supervision. They have less autonomy
over their decisions about how they actually do their work. And importantly for the US, for
an employee to work in the US, they need to have work authorization
whereas a contractor you could hire remotely and
they wouldn't need work authorization. So for contractors, if you decide
that you are hiring a contractor, then you would agree in the contract
how you would actually pay them, and

usually that how the time
on milestone based. So, milestone based would be in our
example, the web designer may be you provide 25% of the fees up front and
you provide the other 75% of the fees when the designer provides
the final design for the website. It's really straightforward for
the company to pay them because they don't have to worry about any taxes being
withheld or anything else like that. So you just pay the contractor and
then at the end of the year, the company will create a form
that's called a form 1099.

Which you send to the contractor so
that they can include the income in their personal tax returns, and
also the company sends one to the IRS. Obviously, that's the US regulation, so
you have a company that's not in the US, then you wouldn't need to file a 1099. And generally if you're working with
a contractor who's not in the US, you wouldn't need to file a 1099 either, but things get a little bit more
complex there, so take advice. On the flip side, paying employees
is more complex for the company.

So, the company pays their employees,
but the company withholds tax on the employees' behalf and
pays it over to various agencies, so IRS, to state agencies, and
sometimes to city agencies as well. So, there's a lot of
calculations in there. It gets very complex very fast if you have
employees all over in different states. And it's more of a headache for
the company. But the IRS prefer it because they
get their tax every time the employee

gets paid. And then so what happens at the end of the
year is the company provides a form W2 to each of the employees and
then the employee uses that to show how much tax has already
been withheld on their behalf. And how much income they have. So, this is a situation where you
should absolutely not be the person calculating all of this. You should use a payroll service provider. It's totally worth the money. It's not very expensive, and they basically take all of
this hassle away from you.

And the company that
a lot of YC startups use, who is a YC company themselves, is Gusto. And they just deal with all of this for
you. It just makes life a lot easier. The other thing to bear in mind is that
under California law, in particular, but other laws as well, employees
are required to be paid minimum wage. So, you can't have somebody working for
you for free and expecting them to be producing work for
the company.

So, do just bear in mind that when you are
hiring people, you do need to pay them. The other part of a startup employee's
compensation package is made up of equity. And usually this is, again,
the part that is the way that they possibly create more wealth for
themselves. It's really important that startup
founders do give employees equity, because it helps to incentivize everybody
to work towards the same thing,

which is creating a successful company. And often in the early days, for employees
they're being paid below market rate, still above minimum wage,
but below market rate. And so, giving them stock in the company
is a way to compensate them for that reduction in cash that
they're potentially seeing. So, it increases their upside. And it's really important that
you are generous with shares, particularly in the early days. Because the people who are going to
be employee number one, two, three, are going to be with you for a long time,

they're going to be working really hard
in the same way tat the founders are. They're going to be setting
how the company goes forward, they're going to be doing a lot of stuff. And so, it's important that they
are motivated in the same way. And as a rule of thumb, you can think
about giving maybe 10% of the company to the first ten employees, but
obviously on a sliding scale, so employee one gets more than employee two,
who gets more than employee three, etc. And the reason why it's not that much of a
gamble to be generous is that all of these

will have vesting, all of these employees
will have vesting on their shares. So, if something doesn't
actually work out and you have to fire the employee, which
when you're hiring people, generally, startups make a lot of mistakes and
have to fire a lot of people. You're not going to be too burnt by that, because the vesting means that the company
has the right to repurchase their shares. The way that companies usually structure
this is they create a stock plan, which is, again,

another bunch of legal documents
which need to be signed and kept. And they, again, can be done on Clerky or
you can use a lawyer to do those for you. And you can either issue shares or you
can issue options from that stock plan. And usually what you tend to find is
that employees are issued options, which means that they have the option
to pay to buy shares in the future, but the price is set now. And so, what this means that's good for the employees is they don't have
to pay the cash immediately.

They can actually exercise their options
in the future when the company is looking like it's successful or
even in conjunction with an acquisition or something, so they don't even
end up any way in out of pocket. And there are some tax
consequences to that which, it's too much detail to go into now. But there's a lot of resources online
about options, about how to issue options, about the pros and cons of them. So, if you're interested,
there's lots out there. Finally, the other thing on this is, it's
really important to communicate to your

employees what they're
getting in terms of equity. So, first of all you need to be clear
to yourself what they're getting. Which means that you need to understand
the number of shares they're getting and what that represents in terms
of percentage of the company. Because if you only give them one and
not the other, it gets very confusing because you can
say, you have x percent of the company. But what that does mean,
x percent of what? Whereas if you say, you have a 100,000
shares, well, what does that mean? Is that a lot of the company or
is that a small amount of the company?

So clear in your head, and then be clear
with the employee about what's going on. All right,
final topic is just a couple of reminders about things that you have to
do to be a legitimate company. So, it's important that you keep all of
these documents that we're talking about in a safe place. You're going to need
them at stressful times. You're going to need
them during acquisitions. You're going to need them during
fundraising due diligence.

You're going to need them so many times,
that if you don't have them all stored in signed format, it's just going
to make your life really hard. So, keep all your documents in
a safe place just assign one of the cofounders to be responsible for this. You should make sure you know your key
metrics in the company, which again, is going to be covered in a lot more
details through out the course. But it's the kind of thing, that again, you just want to have on
the top of your head immediately. And also, you should make sure that
the money that you're spending,

that the investors have given to you,
is being spent sensibly. Spend money on things that will increase
the chances of the company being a success. These investors have trusted you
with their money to try to multiply their money. They haven't given you their
money to go off to Vegas, which happened to one of our
companies a few years ago. Where one of the founders took quite
a lot of company money, went to Vegas, had a great time according to Facebook. And the founders and investors found out,
and that founder got fired.

And actually, he could have
faced criminal charges as well. They decided not to press charges,
but just bear in mind that this is the company's money and
that's what it should be used for. Okay, so in conclusion, that was a really
fast run through of some of the basics. Don't expect you to be
experts in any of this. Don't expect you to have
all of this figured out. But it's just important that you know that
there are some things that you need to do.

And these items up here are sort
of the really key takeaways for this, to just bear in mind as you
go forward with your companies. Okay, I think we have a couple of
minutes for questions if there are any. >> For the employee. Shares, what's generous for,
like the first five employees? When you say the word generous?

>> Well so, you know, it depends, because it depends on the kind
of hires that you're giving. So if your first hire is going
to be a Software Engineer. That's going to be very different if your
first hire is a community manager, say. I mean, for the first 10 is usually
somewhere around 10%, maybe for the first 5, you want to be somewhere in the sort
of 7 to 8 mark, but it really varies. And part of this is you
have to think ahead. So you don't want to be giving employee
number one 30% of the company, and then employee number
two 20% of the company,

because you're going to run
out of company to give them. So it's part of planning ahead for
your hiring needs. >> How much transparency should there be
inside the company of the cap table, and how should that change as
you grow in employees? >> Yeah I mean in the early days, where it's just the founders,
there should be 100% transparency. Everybody should know everything. Generally as the company grows,
it becomes slightly less. You wouldn't share a line by line table
to your employees, for insistence.

But obviously, this transparency is
saying you have this number of shares and the total number of and
the total number of shares is this, is going to give them
the information that they need. Because they only really
care about themselves. They don't care. Well, actually,
that's not true, is it but. >> [LAUGH]
>> They should only care about themselves. They shouldn't care about what
the person next to them is getting. But you wouldn't share that information. >> For organizations that may have
a faster path to profitability, and a longer path to exit, is it still
best practice to give up equity

instead of doing things
like profit sharing? >> I mean, if you're looking at a startup,
you know, the sort of general start up idea of hockey stick growth, and
most of the value is created by equity. It's a good idea to generally
compensate people through equity. If you're looking at more of something
that's kind of more of a lifestyle business. Which can be a great business for two or
three founders who don't take outside money and create a business that's
very profitable from the start. Then yes,
maybe doing some kind of profit share or some kind of very generous bonus scheme or
something like is a better answer.

But usually that's not the case for
startups. Usually they're not profitable for
a long time. >> How did they insert things different
if you have more of non-for-profit or social good based company that's
main prerogative isn't necessarily becoming the biggest x in some field? >> So nonprofits are very different,
because there isn't this idea of owning shares and things, so
that's a whole different idea. And there's also rules around how much
you can pay employees in non-profits.

On the social good companies, it kind of
depends on what sort of a company it is? You know again, you need to decide in
a way of, what's your mentality, and is your mentality still
to be like a start-up? Even though you going to do
some something that gives back, you can still have a startup
mentality in that. And so you probably still want to go down
that path though of having equity and having that conversation in that way. And you can still fund raise as well,
as a social good kind of company.

It's a little bit harder,
but you can still do it. >> So let's say you granted those 10% for
the first 10 employees and then you are going through
another round of funding. Do you dilute only the founders or
also those first employees? >> No, so generally,
well this gets a little bit complex, but the simple answer is that subsequent
rounds of fundraising will dilute all existing shareholders in proportion
to their existing holding. It's a little bit more complex than that,
but that's the general.

>> Yes, so you need to make sure those
employees will know you might be giving them shares now that
represents 1% of the company. But by the time it gets to an exit,
it might represent 0.01% of the company. But in that respect, they probably
have been given more later on, and this idea of the pie being much bigger. So even, you know, 1% of the company
that's worth zero is still worth much less than 0.1% of a company
that's worth $100 million.

>> Just the salient differences between
preferred shares and the common shares. >> Yeah, so
investors get preferred shares and as the title suggests they
have some preferences. And I'm not a lawyer,
I'm a finance person, so I can do this in a very
top level explanation. But basically, they have a bunch of
rights that common holders don't have. So they have things like liquidation
preferences, which means that, when the company exits, they're
first in line to get their proceeds,

to get the amount of the money that they
invested back, before anybody else does. So if, for example, if investors
invested $2 million into a company, and then it got sold, but
the cash was, and sorry. They invested $2 million into
the company and they earned 20%, but the cash that came out of an exit further
down the road was only $2 million. They would see all their money before any
of the common holders, ie the founders, would see theirs. So that's one and there's various other different
protections that they have in there.

That's probably the key role
in the financial basis. But then there's voting rights,
there's rights to first refusal. There's lots of different things and
that's why it's a much more complex negotiation because you have to negotiate
all of these rights within there. >> Is there any specific [INAUDIBLE]
where you see it's really successful on the [INAUDIBLE] setup? And you don't have to say the company,
but who you think? There's like a specific motto that you
think works really well for companies and

schools? >> That's a great question. I think the companies that do this well
are the ones that are transparent. And the ones that sit down with their
employees and really talk through what these things mean and
what options are and how vesting works. Here's a scenario where
some companies will have, if the company exits for this much money,
what does this mean to you? Whereas if the company exits for
this much money how will you see? And so,
they've done all of these calculations and

they really make sure that
employees understand. And I think that's a really
good practice to have. And what that means,
what that needs first, is the founders need to understand it,
which is actually surprisingly not common. [LAUGH] Often, I have a lot of
conversations with founders where they don't understand this stuff. They can't even explain it to their
employees, so understanding it yourself and then being very clear with the
employees, and being organized as well. >> You said you gave say 10% to
the first ten employees, what's-

>> This is not just a rule of thumb. >> Sure [CROSSTALK]
>> Everyone's fixating on it. >> My next question,
the next rule of thumb is, after dilution, roughly how much of the company
do you think, on average, those first employees would end
up owning as an acquisition? >> I mean, it really varies because
it depends when in the life cycle of the company it gets acquired, it depends
how many fund raising rounds there's been. It depends how many more employees
there've been after them. So there's a lot of
different variables there.

I mean, the first money that companies
raise will be the most dilutive. So if an employee comes in, and there's
already been three rounds of money. Then they're probably not going to be
diluted as much as if they were the first employee and then they have to
go through all of that dilution. But it's hard to give a number. >> So could you throw some light on how
at one shares in Facebook were diluted? [INAUDIBLE]
>> No, [LAUGH] I don't know enough of the details, [LAUGH] sorry. >> Do safe notes usually convert to or
into common equity?

>> So safes not safe notes. They convert usually into preference
shares, because again, the investors want all of the rights and privileges
that come with those preferred shares. There are some circumstances
where they might convert into a combination of preferred and
common, but that's less usual. >> Have you seen any different types
of vesting schedules for companies that are on longer term timeline where
the cliff might be longer than a year, and

the total time might be
more than four years? >> I sometimes see companies
push it out to five years. And also, sometimes companies
don't have the cliff at all and they just do monthly
vesting over the period. But the longer the time line,
it's a harder sell for the employees, and so
you've got to be mindful of that. But on the flip side, what usually happens
is, you know if you've had an employee who's been with you for four years,
then they've been fairly diluted.

Because there's going
to be funding rounds, there's going to be subsequent employees,
so you would actually give them a new stock
grant on top of the one they already have. Which would then have new vesting from
the date that you granted it from them. So then they'd have another
four year period there, so that's kind of how you get along,
how you get through the long time period. Okay, last question? >> Have you seen any situation where
somebody can trade a common share for a preferred share or the other way around?

Or is that common? >> So there wouldn't really be a case
where you would trade common shares for preferred shares. There is a mechanic in the fundraising,
in the sort of priced round documents, this allows preferred shares
to be converted into common in various different circumstances. But that's usually around exits and
calculation of proceeds and things like that. Or are you trying to get at
founder's preferred shares?

>> No, I think you just answered it. >> Okay, all right. I think we've run out of time. So thank you very much for
listening everyone, and enjoy the rest of the course. >> [APPLAUSE]
