• When to Fire Your Co-Founders, by Simeon Simeonov (CEO at FastIgnite and former partner at Polaris Ventures);
• What Constitutes a Start-up Mistake, by Simeon Simeonov;
• The 18 Mistakes that Kill Start-ups, by Paul Graham – I guess I was 3 short on my list; and
• How to Pick a Co-Founder, by Naval Ravikant.

Hope you enjoy these articles/posts and the additional info and perspective they add to this topic.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm focused on providing corporate, transactional and operational legal services to start-up and emerging growth companies.

Most serial entrepreneurs know how to steer clear and avoid these mistakes.  Why?  Because they’ve been through it already.  They know the landmines and can generally avoid them.  But first time entrepreneurs, although having a great concept and skills to back it up, most likely have no clue how to get started.  You need to learn from other’s mistakes and avoid making them yourself.  Here’s my list of the 15 most common, but avoidable, mistakes made by high growth start-ups.  The goal here is to have you spending your time building value, and not wasting resources fixing what may be obvious to others.

1.       Making poor early hires and not firing fast enough – I don’t have enough fingers on both hands to count the number of times I’ve seen this happen.  The effect can be minimal or enormous, depending on the position, timing of hire, responsibilities, etc.  Two mistakes I see most often: 

• The C-level hire with an incredible resume of large company, Fortune 500-type experience, but that has absolutely “zero” start-up or emerging growth experience.  Certainly, you want to hire people that have great experience.  There’s no arguing that point.  At the same time, however, you want to make sure that the individual can utilize their skill set in a start-up environment.  Some individuals have built their careers operating under budgets stuffed with positive cash flow – the anti-thesis of a start-up environment.  Never hire someone solely on the basis that listing their former employer on your pitch slides looks great or because you think the company will grow into their skill set (you may turnover a couple of individuals in their role before you reach that size); and
• The hire that claims he/she brings something strategic with them, something that will only come into the fold because of their presence in the company.  I am not talking here about someone that brings a great rolodex, or a specific programming skill or the like.  I am talking about someone that says they have the contacts to help you raise $3M or someone that claims they have the prior relationships to land the 10 largest clients in your target market.  If someone lays claim to something so specific and strategic, and they are to receive a fulsome compensation package based on those claims, then condition some of that package on delivering on the promise.  X options for X amount raised, or X options for every top 10 client you bring in that signs an agreement. 

Consider the real reasons why you are making the hire and consider whether or not such individual may better serve the company at the advisory board level as they may bring significant industry contacts and the like.  Otherwise, just make sure you enter the hiring process knowing the traps that exist.  If you do end up hiring someone that clearly is not working out, then move on quickly.  It may cost you, but not as much as it would in the long run by leaving them in place. 

2.       Failing to assemble the correct management team – the management team that you form is incredibly important.  There are many schools of thought, but I invest in the jockey over the horse.  That’s not to say that the business model and having a large market aren’t important, they are.  Otherwise, you may not be able to develop the kind of return your investor is looking for.  But the team is uniquely important for two reasons: 

• Investors don’t want you learning on their nickel.  I’ve said this before.  For early stage start-ups, you want to see management teams that have some industry experience.  If you are in the technology space and your Senior V.P. of Sales comes out of the steel industry, there better be a great rationale for that.  Demonstrate that you have talent that knows the space; and
• A cohesive, smart management team can make lemonade out of lemons.  See Mistake #13 below.  You know what they say about “best laid plans”.  Nothing is foolproof.  But it wouldn’t be the first time that a smart management team saw a completely separate business model in the ashes.  That’s why you ultimately bet on the jockey. 

3.       Promising portions of equity to individuals in the beginning without a plan - my stomach always turns when I meet with an entrepreneur and they tell me that they struck a great deal with one of their lead employees – he’s doing all of his/her work for 10% of the company.  I can see the excitement in their eyes of having saved cash while getting their platform built.  Then I ask the follow up questions that should have been asked when the deal was struck, and the mood shifts.  Is this deal in writing?  What kind of stock does the employee think he/she is getting?  When and how is the 10% measured?  Is it measured at the time of the agreement or at a later date?  Is the number of shares represented by the 10% calculated on a fully diluted basis or not?  Can the 10% be diluted (i.e., if that 10% translates into 500,000 shares of common stock, will those 500,000 shares represent 8% when the outside investors put their money in or does the employee expect to be issued additional shares such that he/she still owns 10% following the outside investment)?  In other words, did you inadvertently agree to let them have 10% of the company forever.  Persons of reason laugh at the thought that anyone could think they’ve been given such a sweetheart deal.  Think again.  If you’ve just hired a very opportunist employee, they may have no qualms trying to hold you to a deal many would say borders on ridiculous.  Then it becomes a matter of how much you would pay to avoid litigating such an issue when you should be building your company.  This is an amateur mistake that is 100% avoidable. 

4.       Failing to properly structure founder shares - once you’ve decided who the founders are going to be, you’ll need to structure your founder shares.  Founder shares embody the concept that if a founder receives all of their shares upfront, fully vested, then there’s no incentive to stick around and help build the company.  That founder could walk one day, keep all of their shares and piggyback on the hard work of the remaining founders.  Founder shares usually vest over a period of time and are issued as restrictive stock grants.  By way of example, a founder may be issued a restrictive stock grant of 400,000 shares of common stock, vesting annually/monthly/quarterly over 4 years.  If the founder stays for the full 4 years, he/she keeps all 400,000 shares.  If the shares vested annually and the founder leaves 2 1/2 years later, they keep 200,000 shares (the company usually buys back the remaining 200,000 shares at the same price the founder paid for them).  If they are fired for cause, it is possible that they could lose all of the shares.    If there is just one founder, there is really no issue until such time that the company seeks to raise outside capital.  At that time, the investors may insist that the founder put some of their shares on a vesting schedule – again, to align both founder’s and investor’s incentives.  If there are multiple founders, then this is something that should be put in place at formation.  For some further info, see both of these articles from Mark Suster regarding Founder Prenups and Founder Vesting. 

5.     Picking the wrong type of entity and structuring early ownership 50/50 – see my earlier posts regarding picking the right type of entity and the difference between entities.  In my humble opinion, if you plan on seeking outside investors, then go with the corporate structure.  You avoid the whole issue of VC funds requiring blocking entities (a result of some of their limited partners being non-profit companies) and the possible need (and accompanying cost and time) to convert your limited liability company to a corporation at a later date.  In terms of how you structure ownership, if there are two founders then find some difference between yourselves to rationalize one person taking 51% of the ownership.  50/50 deals, absent some complicated deadlock breaking provisions, simply result in a standoff the minute the founders disagree.  In order to make the 51/49 split more palatable, you can give the 49% owner comfort that he/she will have a say in material decisions (e.g., taking on debt, sale of the company, major hires, etc.) by giving the 49% holder certain protective provisions (i.e., the need to obtain their consent in order to approve these material decisions).  If you do provide protective provisions, then make sure you look at them in the totality.  You don’t want the exception to become the rule and end up in a 50/50 situation inadvertently.  

6.       Failing to consult experienced advisors at the beginning – many of the mistakes in this post could be avoided by simply hiring experienced start-up and emerging growth attorneys and accountants from the very beginning.  See my earlier post regarding hiring start-up counsel.  First time entrepreneurs may balk at this, serial entrepreneurs do not.  Serial entrepreneurs know that they will save time and money resources (far in excess than they would have saved in reduced fees by going with inexperienced counsel) in the long run because they eliminate the clean-up necessitated by lawyers that don’t know what they are doing in this space.  Hiring experienced counsel doesn’t mean the big price tag it used to mean.  Contrary to many years ago, the marketplace has many start-up and emerging growth experienced attorneys at reasonable rates (see my earlier post on the changing law firm market).

7.       Not having a clear business plan – the mantra here is focus, focus, focus.  If you try to become all things to all people, you will likely end up being nothing to nobody.  Investors back business plans that are clear and show some rational path to acceptable returns.  I would advise having your attorneys and accountants also review your plan.  If you are following my suggestion in Mistake #6 above, those attorneys and accountants see many plans and can provide helpful comments to improve and refine it.

8.       Raising too much or too little money – raise too much money and you may have just bought yourself complacency (along with many of the other mistakes in this post).  Too much money allows for making poor early hires (Mistake #1 above), consulting experienced but not cost-effective counsel (Mistake #6 above), losing direction (Mistake #7 above) and spending endlessly or needlessly (Mistake #11 below).  Raise too little money and your runway may be cut short before you launch your product or have built enough to support raising additional funds.  Planning and projections are the name of the game here.  You need to look into the future as best you can and consider how much money you will need to reach the next fundraising stage.

9.       Failing to properly document early agreements – there are early internal agreements to think about, and that experienced counsel can help you prepare, such as (i) shareholders’ agreements between the founders, (ii) founder share agreements and possible 83(b) elections, (iii) non-competition, non-solicitation, confidentiality and invention assignment agreements for employees (these are critical, particularly for employees that are building your product, as you might not own what they develop without them), and (iv) proper equity compensation plans (i.e., stock option plans), and option grant agreements.  There are also early external agreements such as customer contracts, service agreements, licensing agreements, office leases and the like that need to be prepared.  I’ve seen scenarios where early stage start-ups leveraged the existence of early customer contracts, but due diligence by VC funds later uncovered that those contracts were not as strong as previously thought.  Use of experienced counsel early on will provide some assurance that the contracts contain the appropriate protections.

10.       Raising early money without complying with the securities laws – no matter how you slice it or dice it, if you are selling a stake in your company then you are most likely selling a security which means you need to comply with federal and state (blue sky) securities laws.  This is true starting with the issuance of founders shares all the way up to issuing stock to VC funds and beyond.  The key here is to make sure that the transactions are structured in a way that you can claim an exemption to the requirement of registering the sale of the stock.  It is very important that you properly structure these transactions because poorly structured transactions (i.e., those that don’t satisfy all of the requirements of an exemption) will cause significant problems down the road.  They can derail future fundraising or cause the company to expend tens of thousands of dollars to later rectify.  Properly structured, exemptions exist for shares issued to founders, and to employees under equity compensation plans and to VC funds.  Most securities sold to outside investors are structured to comply with Rule 506 of Regulation D pursuant to the Securities Act of 1933, as amended.  You will save yourself significant heartburn later on if you take the time to structure these sales correctly the first time.

11.       Poor cash management and spending money on the wrong things - California Historic Landmark No. 976 – the “garage” where Bill Hewlett and Dave Packard started Hewlett-Packard in 1939.  Simple beginnings for what is now a billion dollar behemoth.  That garage epitomizes boot-strapping.  Fast-forward to the mid-1990’s to late 1990’s, during the internet boom.  Companies with only a business plan and little or no product were raising millions of dollars at hyper-inflated valuations.  Many of these companies managed their cash poorly or otherwise spent their money on the wrong things.  Enormous, beautiful offices and brand new furniture.  Artwork.  Game stations.  There was seemingly no end in sight, until the whole thing imploded in mid-2000.  Today’s start-ups seem to have learned some lessons from those days.  You see more group-share offices, people buying used furniture off of eBay, jamming 20 employees into 4,000 square feet of Class C office space.  You also see less tolerance for poor cash management.  We all know “cash is king” and you really, really need to think about every dollar that goes out the door and what you are getting in return.  You need to show investors you have the discipline to manage the cash to reach positive cash flow.

12.       Failing to identify a market for your product/service - having and developing a product or service is one thing, but finding someone to buy it is a whole other story.  Unfortunately, some entrepreneurs make the mistake of investing time and money into building the product or service before they’ve even considered who is going to buy it or how you are going to market and sell it to them (see Josh Kopelman’s article regarding customer acquisition plans).  The investors that most often suffer from this mistake are the founders themselves, friends and family and, sometimes, angels.  Very often it is the technical entrepreneur that may get caught up in this problem as their skill set tends to focus them on product capabilities and features and maybe not sufficiently on the need for those capabilities or features by the potential customer.  The mantra here is to fail as early as possible.  Try to identify what the customer wants and doesn’t want early in the process in order to reduce the amount of time and money resources focused on that feature.  This mistake is not just made by early stage start-ups, as companies mature and launch new divisions and products, this mistake still ranks near the top.

13.       Not being able to re-invent as you go - in the movie Heartbreak Ridge, Clint Eastwood starred as a gunnery sergeant in the U.S. Marine Corps.  Anytime his soldiers would run into an obstacle or an unexpected problem, he would tell them ”improvise, adapt and overcome”.  This is the perfect mantra for an early stage start-up.  As I mentioned in Mistake #2 above, even the “best laid” plans run afoul and you need to be able to turn the ship on a dime and possibly take a different tack on the problem.  Many say the difference between success and failure is only one factor.  A capable and creative management team may be able to salvage the company by re-inventing it along the way.  As the business grows, this skill set is still very useful.  There were many companies that needed to re-invent themselves as of late in order to compete with some of the very capital efficient business models that currently exist.

14.       Hangups on valuation rather than focusing on getting committed funds to make a successful business - I would like to thank Bob Fesnak of Fesnak and Associates for this Mistake #14.  You can see my earlier post for more information on this subject.  I place higher negotiating priority on liquidation preference and dilution than I do valuation.  Don’t let your hangups over valuation stifle your change of closing on committed funds.  Without the funds, there is no business.  Read my earlier post in depth.

15.       Failing to build a sustainable business around intellectual property - I would like to thank Bob Fesnak of Fesnak and Associates for this Mistake #15.  It’s a classic and goes hand-in-hand with Mistake #12 above.  Intellectual property is only one leg of the stool.  You need all of the legs if you want the stool to stand and not wobble or fall down.  The only way to monetize intellectual property is to build a sustainable business around it.  This is the gap that technology transfer offices at the university level try to overcome on a daily basis.  Intellectual property is created as part of the academic or research and development process and the university or professor desires to realize some value from that intellectual property.  However, the university lacks the other legs to the stool and has to seek the private sector’s help to fill in the gaps.  Technology transfer offices do this by partnering with entrepreneurs who can license that intellectual property and build a company around it.

You’ll find many other lists on the internet that focus on costly mistakes made early in the start-up process.  For additional resources, I would point you to 25 Entrepreneurial Death Traps, by Fred Beste (Partner Emeritus at Originate Ventures).  Fred is a great guy (and VC) and Originate Ventures is a great group to affiliate yourself with and to raise money from.

Thank you and I welcome your comments or questions.

Here are some other aspects of boards of directors and boards of advisors that may be helpful for you to know:

• Purpose and Responsibility:  A board of directors is a requirement in any corporation (a board of managers is not a requirement in a limited liability company, but if you choose to form an LLC and intend to raise outside capital, then I highly suggest you put such a board in place).  See my earlier post on choice of entity.  A corporation is an entity that is not corporeal.  Therefore, the board of directors represents the physical body of the corporation and has direct responsibility and fiduciary duties (such as the duties of care, loyalty and candor) to the shareholders of the corporation.  A board of directors, however, does not manage the day-to-day affairs of the corporation.  Managing the day-to-day affairs of a corporation is strictly a function allocated to management (i.e., CEO, COO, CFO).  It is the board of directors’ obligation to oversee management, to make sure that management develops strategic plans, executes them and delivers value to the shareholders.  A board of advisors, on the other hand, is not a requirement, but most start-ups have them anyway.  A board of advisors has no legal responsibility or fiduciary duties to the shareholders.  The purpose of having a board of advisors is to add a layer of diverse expertise above management that can offer support, advice and assistance without the corresponding responsibilities and fiduciary duties of directors.  Both boards must be actively managed in order to maximize their usefulness.
• Size:   There is no limit, but most boards of directors range in size from 3 to 10 or more.  Most privately held start-ups will have a board of directors ranging in size from 3 to 5.  Publicly traded companies tend to have larger boards of directors.  You should structure the board of directors to include an odd number of directors so that there are no deadlocks.  Most boards of advisors range in size from 5 to 20, depending on their focus and purpose.  A larger number of advisors may exist in bio or scientific start-ups where more technical disciplines are required.
• Composition:  Both boards of directors and boards of advisors are formed early in the company’s existence.  The board of directors is formed at the time of incorporation and generally consists of one or more founders to start.  A board of directors is usually guided by a Chairman.  The board of advisors is generally formed shortly after the company is incorporated and initially consists of your well-connected start-up and emerging growth lawyer and accountant.  Over time, both boards will grow.  The board of directors, following funding, will grow to include investor representatives as well as independent directors.  The board of advisors will grow during each phase of growth, by adding people that provide value during that phase.  Founders should look outside their network when building their board of advisors and should seek diversity.  Steer clear of building a reflection pool (i.e., a homogeneous board of advisors that look and think like the founders).  The goal here is to bring the perspective of diverse disciplines – to build a true sounding board off which you can bounce ideas and issues.  Do not build a group that ratifies and legitimizes poor decisions.  Also, an important characteristic of any advisor that is chosen should be the ability to make key introductions to support services, vendors, customers and the like.  Stay away from appointing family members to either board, unless their qualifications otherwise meet those laid out for either board (viewed objectively).
• Meetings:  The frequency of meetings may change over time.  There is a lot of decision making compressed into the first year of a start-up and, therefore, the frequency of board of directors’ and board of advisors’ meetings is high.  In the very beginning, both boards may meet monthly and then eventually that schedule may move to bi-monthly or even quarterly.  Management must take the initiative in making sure that board of directors meetings are run smoothly and efficiently and that board packages (consisting of an agenda and other materials requiring review by the board prior to the meeting) are distributed to allow ample time for review by the directors.  The board of advisors may not have a set meeting schedule, with management only calling meetings when they require the special insight of the advisors on a particular issue or set of issues.  However, if your advisor meetings are infrequent, make sure you nonetheless keep your advisors in the loop so that they have the benefit of legacy and historical event knowledge when helping you work through difficult issues.  You don’t want to have to bring your board of advisors up to speed every time you need to vet an issue with them.  Directors have an obligation to keep their discussion confidential, however, you should impose that same obligation on your advisors by way of a confidentiality agreement.
• Compensation:  Both board members are generally compensated.  The directors, given that some board meetings take place in person, are usually paid a small cash fee for attendance, plus reasonable expenses if they must travel.   They may also earn an annual fee for their services, although this is unlikely in the start-up stage.  The advisors, on the other hand, may or may not be paid a cash fee.  The significant portion, however, of both directors’ and advisors’ compensation is usually received in the form of restricted stock or option grants.  The goal is to align a directors’ or advisors’ interests with the shareholders’ interests by providing equity that vests over time.

Please let me know any comments you may have.  I would love to hear them.

So, why are limited liability companies notthe preferred entity structure for a VC-backed company?  First, the flow-through-tax status of LLCs can wreak havoc on a venture fund’s limited partners as it may subject them to UBTI (Unrelated Business Taxable Income).  They may be forced to recognize income from the investment even though they have not received a distribution to pay for the resulting tax.  Some VC funds have employed unique blocker entities to avoid these taxes but these methods are not surefire.  Once an entity like a VC fund invests in a corporation, it will take on C-corp status, thus eliminating any flow-through-tax issues for limited partners in the fund.

Second, LLCs cannot issue certain types of stock options nor can they adopt a stock option plan (often the source of non-cash incentives for founders and other early members of management).  Corporations don’t have this problem.  They can issue restricted stock options, incentive stock options, non-qualified stock options and so on, all through a stock option plan adopted by the company. 

Third, to the extent IPOs ever return as a possible venture backed company exit strategy, people perceive that trading shares in a corporation is easier than trading membership interests in a limited liability company.

Fourth, corporate law (particularly in Delaware) is well established.  There is substantial caselaw on all sorts of issues which makes outcomes more predictable.  Predictability helps eliminate risk, which VCs like.  It’s a comfort factor.

Lastly, LLC Operating Agreements that have multiples series of preferred membership units (like you would have in a VC-backed LLC) can get extremely unwieldy.  I can attest to the difficult drafting that is required to make all of the LLC provisions flow consistently and work together, particularly with multiple series of preferred membership units (LLC vernacular for shares).  Creating series of preferred stock in a corporation is much simpler.

I would suggest that LLCs are a better entity for mom-and-pop type businesses, lifestyle companies, professional service companies and as subsidiaries of larger companies.  Interestingly, many VC funds use LLCs as the preferred structure for their general partner entities.

What to do if you’ve already formed as a limited liability company and intend on seeking outside sources of capital from the likes of venture capitalists?  Most likely, a VC that is interested in investing in your company will make it a condition to closing that you convert your LLC into a corporation.  It gets more complicated if you’ve already got multiple series of preferred membership units in the existing LLC, but such a conversion can be done with some added time and cost.  You simply merge the LLC into the new corporate entity.  Some VC funds may even require that as part of this conversion you re-incorporate the entity in Delaware (a preferred state of incorporation).  I’d suggest you save yourself the time and cost of conversion by going with the corporate entity from the beginning.

The first thing you should know is that people run their business through a corporation or limited liability company because they desire to limit their liability to third parties.  How does that work?  If corporate formalities (e.g., having Board and shareholders meetings, electing officers, hiring accountants and bankers) are followed by the shareholders, then only the capital invested by the shareholder is at risk.  Someone would have to pierce the corporate veil (generally a difficult task) in order to hold a shareholder liable for more than their invested capital.  By providing limited liability, states encourage individuals to take the risks associated with growing a company.

Corporations

Corporations have traditionally been the vehicle used by for-profit entities.  There are two general types of corporations, with one of the primary differences being how they are taxed.  Regardless of which type of corporation you choose, operating through a corporate entity provides shareholders with limited liability. 

The first type is a C-corp.  A C-corp has two levels of taxation.  First, corporate income is taxed separately at the entity level.  Later, if any distributions are made to the shareholders, then those distributions are also taxable to the shareholder personally.  C-corps have no restrictions in the number of shareholders or in the types of stock that it can issue.

The second type is an S-corp.  S-corps have some limitations that C-corps don’t have.  To qualify as an S-corp, the entity cannot:

• have more than 100 shareholders;
• have shareholders other than individual U.S. citizens or permanent residents (with some limited exceptions);
• cannot have more than 25% of its income generated from passive activities (think landlord); and
• can only issue one class of stock (except that you can have both voting and non-voting common stock).

In return for qualifying as an S-corp, the entity gets the benefit of having a flow-through-tax status meaning that the entity itself does not pay a separate tax.  “Flow-through” meaning the tax flows through the entity straight to the shareholders.  In effect, it eliminates the tax on corporate income at the entity level that you have with a C-corp.  All of the taxes of an S-corp are paid by the shareholders themselves through their own individual tax returns.  Once an entity no longer qualifies as an S-corp, it converts to a C-corp.

Putting aside the tax issues and the qualifiers for being an S-corp, no real differences exist between S-corps and C-corps.

Limited Liability Company

A limited liability company is a hybrid model that provides a bit more flexibility over an S-corp or C-corp.  In fact, it provides limited liability just like the corporation, but it allows for both individuals and entities to be members (LLC vernacular for shareholder) without altering its flow-through-tax status.  That’s why LLCs are popular in some crowds, because they blend the favorable aspects of S-corps and C-corps.  LLCs are generally governed by a Limited Liability Company Operating Agreement.  Anyone can be a member, there is no tax on corporate income at the company level and members can agree to divide profits in ratios that aren’t synonymous with their ownership ratios.  The last point cannot be done in an S-corp or C-corp.

That being said, I view limited liability companies as being more appropriate for lifestyle companies, mom-and-pop type operations and professional service organizations.  Most venture backed companies tend to be corporations.  In addition, sole proprietorships, general partnerships and limited liabiliy partnerships are not structures that you typically see utilized in venture backed companies, for reasons too detailed to express in this forum. 

As always, consult your accountant when picking the proper entity.