In the earliest days of a startup, the founders are hugely optimistic and driven. But they also know about the low odds of reaching the point of having paying customers and even lower odds of reaching $10M in annual revenues or some interesting exit. At the same time, they don’t have enough cash to do everything “the right way”, which means they cut a lot of corners. In other words, they don’t worry about doing many things “by the book”. They decide to worry about that later when they have the luxury of cash in the bank and a less than 70-hour work week. But the reality is there never seems to be a good time to go back and fix the cut corners. The accumulated by-the-book debt will eventually come due and the later that happens the more painful it is. Let’s explore further.
Defining “By the Book” Debt
“Technical debt is a metaphor that equates software development to financial debt. Imagine that you have a project that has two potential options. One is quick and easy but will require modification in the future. The other has a better design, but will take more time to implement. In development, releasing code as a quick and easy approach is like incurring financial debt – it comes with the obligation of interest, which, for technical debt, comes in the form of extra work in the future.”
My definition of by-the-book debt is basically the same thing – taking the quick and easy approach to various business decisions rather than the most disciplined, legal, ethical or manageable ones.
This article will review the most common instances of by-the-book debt that I see as a startup advisor, investor and board director. After reading the rest of this article, I recommend that you assess your current level of risk using an assessment tool I created that you’ll find at the end of the article.
What’s the Big Problem?
Startups are told things like “move fast and break things”, “don’t waste time on a business plan” and “fake it until you make it”. The spirit underlying those sayings are valid but the interpretation can be either taken to an extreme or continue for so long that the success of the company could be placed in jeopardy.
Most of the items I review in this article are of the type to become discovered during Series A/B fundraising or acquisition due diligence. Some of them might actually come to light because of a disgruntled employee, co-founder, service provider or business partner.
The big problem comes in actually remediating (fixing) the issues. Doing so takes time, effort and often money. Many early stage startups think things will get easier if they can just get to ______ (insert some financial milestone). I often tell startups, “Building a great company never gets easy. It remains really hard but just in different ways over time.” The truth is there’s never going to be a good time to fix the accumulated by-the-book debt. And I can tell you that the longer you let it accumulate, the more painful (and potentially devastating) it will be to fix.
Not all forms of by-the-book debt are equal in terms of risk or remediation effort. Below I’ve grouped them into two categories. My strong recommendation is to never concede on the items in the “Critical” list but instead stay by-the-book if at all possible. Otherwise, the future pain WILL be excruciating.
Critical By-the-Book Debt (Avoid if At All Possible)
Co-Mingling Business & Personal
In the very early days, you might be inclined to incorporate as a simple LLC or even sole proprietorship. There’s no problem with that but don’t mix various financial or legal activities between your personal and financial accounts. The most common issues relate to bank accounts, credit cards, salary payments, expense reimbursements, and filings or registrations for various intellectual property (trademarks, website URL, patent filings, etc). From the very beginning, once your idea merits the incorporation of some business entity, cleanly separate these activities.
Verbal agreements are subject to very different interpretation by the involved parties and that interpretation can easily change over time. I’m not talking about verbal agreements amongst the founding team related to the product roadmap, pricing strategy and things like that. We don’t need or want legal documents for those sorts of things. Instead, I’m talking about legitimate things that could later lead to legal claims by those that feel like they were wronged in some way.
Take something important like the amount of equity each co-founder will get and their associated vesting schedule. If that isn’t properly documented with the help of an attorney, anything that causes a co-founder to become disgruntled, leave the company, or simply decide the arrangement is no longer fair will result in a big mess to remedy. Just the process of trying to resolve the dispute could kill the company, either because of the legal costs, timeframe to resolve and/or distraction from advancing the business forward.
Related article: “Avoiding Co-Founder Conflict“
Never assume verbal agreements are OK for important business matters. Even a signed letter of intent (LOI) is better than nothing if you need to start with something (check out my Legal Resources for some sample LOI templates). Your attorney can best advise you when a full legal agreement is needed versus something like a letter of intent (LOI) or memorandum of understanding (MOU).
Approvals – For anything that relates to rounds of funding, make sure you have proper approvals ahead of time. In order to do this, you and your attorney will need to follow the process that your incorporation docs require.
Investment Docs – Every investor must sign the required documents that correspond to their investment and this should be done in the same timeframe as their actual investment (usually shortly prior).
Accredited Investor Status – Almost all forms of selling equity in your company (including when using convertible securities) require you to raise money only from accredited investors, as defined by the SEC. Very few exceptions apply. So if you’re raising money from your 25 year old sorority sister or your Aunt Sally, make sure to have reason to believe they are accredited investors.
Numerous actions that you take require prior authorization by your board of directors, even if you are the only member of the board and don’t have regular board meetings. Examples include authorizing new shares of stock, issuing stock into the company, creating a stock option plan, granting stock options to an employee/advisor/etc or warrants to a service provider, taking on significant debt, raising money, and changing the fair market value of your various classes of stock – and there are many more examples that your attorney can explain to you.
Paper up these board resolutions using the help of your attorney and file them away in your legal archive (see a suggested hierarchy for this archive in my Legal Resources section) because a future VC fund or acquirer will want to confirm they exist for ALL required actions.
Do you fully own all intellectual property that has been developed for your company? Are you absolutely certain? What about that friend that helped you in the very early days when your company was just an idea? Did she sign a document assigning all of her work product to the company? How about that boutique development shop in Mexico that created your MVP? How about every employee that has ever worked for your company (including yourself)?
Your attorney will provide you an IP Assignment template to use for these situations. Use it with EVERY person or entity that contributes work to your company, unless the consulting agreement or similar that you used accomplishes the same thing.
Open Source Software
Using open source software (OSS) is not a problem at all and is common practice today. But not all open source license types are equal in their requirements. Failure to properly document your use of OSS is going to create big problems later when an acquirer wants to know how each and every instance was licensed and whether you modified the code in such a way that requires contribution of those enhancements back to the open source community. If you don’t take this seriously from the very beginning, it’s almost impossible to figure it all out later. That’s why I have this in the “Critical” section.
Educate yourself on this matter and discuss it with an IP attorney. Below are some articles and resources I have produced on this topic:
- Article: Misuse of Open Source Software Can Kill Your Acquisition Exit
- Article: A Tale of Two Acquisitions – Part 1
- Resource: Open Source Usage Policy (in the Legal Resources section)
83(b) Filings with the IRS
For early stock option exercises that require this IRS filing, it must be completed within a short timeframe of being issued the stock (at the time of this writing it’s 30 days). Not doing so is a big, big problem because there are competing opinions on whether a viable path to correction exists.
Additionally, you should make sure to get a copy of each 83(b) form that was filed and archive that for your records. Even better than a regular copy is a file-stamped copy from the IRS, which requires the filer to include a cover letter with that request, an extra copy of the 83(b) and a self-addressed stamped envelope.
Download a cover letter template with associated guidelines for 83(b) filings here (see the Legal Resources section).
Important By-the-Book Debt
The following issues aren’t generally as critical or carry as much risk as those mentioned above. But it’s one thing to ignore them or drift a bit from “center” in the early days of your company’s evolution and another to let the issues continue as you grow and become a viable and scalable company. Left unchecked for long periods of time, these issues will actually become Critical.
Few startups are rigorous enough in the early days (before Series A financing) to follow US GAAP or international IFRS standards to the full letter of the law. And that is possibly OK as long as you don’t drift “too far from center” because doing so will likely cause due diligence issues when you’re ready to raise money from institutional investors or you’re approached for acquisition.
Revenue recognition practices are the most common issue encountered. This includes things like revenue reversals and bad debt reserves that either don’t exist or are done incorrectly. And if you’re a services company or there are services required before your product can be utilized, the proper timing of revenue recognition is also sensitive. Another issue that is sometimes encountered is the mixing of cash accounting and accrual accounting methods (pick one).
Even if you don’t decide to hire a CPA on an on-going basis but rather just want to use a part-time bookkeeper, consider having a CPA get you pointed in the right direction on these items early on by working with your bookkeeper and properly configuring your accounting system. And the closer you get to a Series A financing the more you want to start falling in line with official accounting standards.
Like the accounting-related issues mentioned above, setting the price for your various classes of stock takes on increasing importance as your business becomes more viable and starts to grow. Once you’re generating meaningful and consistent revenue (subjective, but I’ll suggest that this might be something like $20-30K in MRR), you want to follow the proper procedure by having a 409A valuation done by a certified professional.
For more information about pricing your stock in the early days, see my related article here.
Some service providers will agree to defer payment of their fees until you raise a certain amount of money or reach some financial milestone. There’s nothing ethically wrong with this. Rather, the issue I sometimes encounter is a startup that somehow seems to forget that the payment will eventually come due. Possibly the best way to avoid that is to register the deferred fee in your accounting system as a liability so that you’ll at least see it when periodically reviewing your balance sheet with your co-founders, advisors or board members. And don’t forget to have your service provider send you statements on a monthly or quarterly basis so that you can see how much of a total fee has accrued.
Benefiting from Experience
The issues and associated risks presented in this article are most commonly found in startups run by first-time founders that don’t have much prior business experience. It’s only natural that they wouldn’t have the knowledge needed to play things just the right way. This is one reason why advisors and experienced executives can be so valuable (see related article titled “Selecting an Advisor”). Many of the scars they have in their back are from making prior mistakes like the ones mentioned here. You can gain hugely from that experience.
Even experienced founders cut corners and accumulate some by-the-book debt in the early days but the best ones make some priority to solve/resolve as soon as practical. And they also understand the difference between the “critical” versus “important” designations that I’ve used here.
I’d like to suggest that your Board directors will ask enough hard questions to help discover your various accumulating by-the-book debt, but don’t count on that. You probably only interact with them formally once per quarter and perhaps casually in between. If you don’t present sufficient detail to cause a concern, they might not think to push you there. In fact, board meetings often don’t get into a lot of details like what I’ve mentioned here. YOU ARE THE ONE THAT IS ULTIMATELY RESPONSIBLE AND ACCOUNTABLE.
Related article: “Your First Board Meeting”
Lawyers and accountants are probably the best to educate and advise you on the boundaries to not cross and the best timing and methods to remediate. So pick your lawyer and accountant wisely. The more they let you do whatever you want without warning, the more danger you could find yourself in.
- Complete my By-the-Book Risk Assessment to see where you current sit (link and embedded form further below)
- Stay completely away from “Critical” by-the-book debt
- Keep “Important” by-the-book debt to a minimum, both in instances and severity/extent
- Make a list of where any by-the-book debt exists and make sure your co-founders, other company executives, board members and key advisors know about it. This will help ensure it doesn’t get “swept under the rug”.
- Decide when it’s appropriate to start fixing or improving each instance.
- If you already have issues listed in this article as Critical, start addressing them as soon as you’re done reading this article. Seriously.
- Realize that the longer a mistake goes unrecognized and unpunished, the more a person tends to convince themselves that it’s OK. This is basic human psychology.
I hope this article gave you some valuable insights and tools to help you build a great company!
If you would like to see where you sit on the by-the-book risk scale, use the assessment tool below. After doing so, work on any needed items based on your current stage of evolution and then come back and score yourself again.
Click Here to Assess Yourself via a web browser form -or- Use the Embedded Form Below: