C-corp is the Right Corporate Structure

Occasionally the question comes up as to whether or not a start-up should be a C-corp, S-corp, LLC or partnership (there's also sole proprietorships, but no one reading this wants to be a sole proprietor). The answer, simply put, is that unless you plan on being a small business with very few shareholders forever, you should be a C-corp.

Every large corporation (that I'm aware of) is a C-corp. It is the classic corporate structure, offering protection to shareholders from creditors (known as the "corporate shield"), unlimited stockholders and preserving all tax obligations / rights to itself. A key principal of C-corps is that each class of stock should be treated equally within itself, implying that while the rights of different classes can be different and complex, analysis of a capital structure can be focused at the class level rather than needing to get to the individual shareholder level. The main criticism of C-corps is that there is double taxation of any earnings dividended out to shareholders. This is because the company pays taxes on the profits and then the shareholder pays taxes on the dividends. Since most start-ups don't pay a lot of dividends, this isn't a major concern.

S-corps are an old structure that is rarely used now. They allowed for pass-through taxation, which was a benefit for small companies whose owners were often the founders themselves and had to pay out large bonuses to avoid the double taxation issue, thereby distorting their financial results. For unprofitable start-ups, the losses can be passed through to wealthy angel investors, allowing the benefit of those losses to be realized faster than in a C-corp (where they are effectively trapped until the company becomes profitable). On the flip side, S-corps can't have VCs or even foreigners as shareholders, so it really isn't a great option for most start-ups.

Partnerships are much more flexible than corporations. Profits and losses can be allocated partner by partner as fits the needs of the partnership. On the other hand, all general partners (and there must be at least one), carry personal responsibility for the liabilities for the partnership (ie - no corporate shield). These structures are rarely logical for start-ups that need to raise successive rounds of external capital to be used in operating the business. They make much more sense for law firms, venture capital firms and other 'people-intensive' businesses where the business might cease to exist if the prinicpals were no longer involved.

LLCs are a new structure (circa 1990) that combined the pass-through capability of S-corps and partnerships but retaining the corporate shield of a C-corp. However, once set, the structure is relatively inflexible and major changes can trigger the wind-down of the LLC. They are appealing to some angel investors but VCs can not take advantage of the pass-through losses.

The initial holding entity for Expo was an LLC because the paperwork can be very simple and cheap to file. However, as soon as we brought in the first external financing, we created a C-corp which bought all of the assets of the LLC and in return gave all of the common stock of the C-corp to the LLC. Because there was no value in the company, this was a tax-efficient and relatively simple transition.

Last but not least, you should probably register your C-corp in Delaware. The costs are low and all lawyers are familiar with the rules and standards in Delaware...Delaware law is the "english language" of the corporate world. No, you never have to go there.

Although this was all based on personal experience, I did do some fact checking on this very helpful page on all business structures from H&R Block and suggest you check it out as well.

Basic Securities and Structural Elements in a Venture Backed Capital Structure

On May 30, 2007 I published a post called How to Value Your Angel Round on how to think through valuation for your first external financing. In that post, I promised that the next post would be a basic explanation of capital structure concepts for start-ups. Well, I lied. Although we've talked around some of the issues from time to time, we've never really covered these concepts as promised. But today is the day!

Last bit of wind-up, I'm only going to cover securities appropriate in a C-corp. The next post (I promise! I already wrote it...I just have to push publish!!) will cover why you should choose a C-corp.

Every C-corp starts with common stock. Common stock defines the basic "unit" of a share. Convertible securities given to some investors generally convert into common shares. Employee options are exercised for common shares. Common shareholders as a class have rights, such as being able to elect some or all of the directors of the corporation and to vote on certain other matters. Many shareholder votes occur as if all convertible securities had already been converted (but optionholders generally cannot vote until they have exercised their options).

When public companies raise "equity" capital, they are generally selling common stock. In fact, when a public company sells preferred stock or convertible stock, much of the valuation is based on the debt components of those securities (ie - the interest or dividend promise and the high likelihood of the preservation of the capital invested). It's very different for private companies.

As I've written elsewhere, I think all investors in start-ups should get preferred stock.  This is because the preferred security holders will not convert their shares to common unless they are "in the money" (ie - above the price they invested at). Otherwise, they have the right to request the return of their capital (or more, as we'll soon see) before other shareholders can take any proceeds from a transaction (as a side note, this has the effect of driving down the effective share price other shareholders receive).

Before we get to those "or more" situations, there's one more important point. Most start-ups raise more than one round of preferred capital. Typically, each round is senior to the prior rounds. So, in a sale of the company, the most recent round gets first 'dibs'. If the most recent capital raise was, for example, $5mil and the company is sold for $7mil, the most recent investors would get their $5mil back and all other shareholders would share in the remaining $2mil (most likely to go entirely to the round immediately prior unless it was smaller than $2mil).

OK, but how can preferred shareholders attempt to "guarantee" getting even more than their capital back? These are called sweeteners and they come in several varieties, but they all have the same basic purpose, which is to enhance returns. There are:
1. cumulating dividends: typically, preferred dividends in a start-up aren't paid out as cash, but rather they accumulate on the preference. If the ultimate proceeds from a transaction exceeds the preference plus the accumulated dividends, then the dividends are of no effect. However, they do increase the "preference stack" by the amount of the dividends each year, usually 6 - 10%
2. multiple preferences: just like it sounds, in these cases the preferred shareholders have a right to a multiple of their capital before common or other shareholders are eligible for proceeds. This is less common and when used, generally it will be a 2x but have heard of 3x.
3. participations: this one sounds nice and benign, but its a strong one...a participation means that the preferred holder gets their capital back and then still gets the benefit of their full converted ownership. Although in some cases it wouldn't give the preferred holder economics as attractive as a 2x preference, the challenge is that no matter how well the company does, the fact that this capital has to come out off the top reduces the return for all other shareholders. There are even cases of multiple participations which make me wonder if the managers of those companies knew what they were signing.

Although I've been on all sides of sweeteners (asking, getting and subject to someone else's), in a 'normal' situation I think they are fundamentally a bad idea and I think most people, even VCs, agree. Why? They create perverse incentives for managers who realize that their opportunity for upside is buried under a pile of preferred shareholder economics. Those managers are then incented to "throw for the long ball" in an attempt to catch up. Or, they may just give up entirely and start looking for the next opportunity. In either case, all of the shareholders are put at risk...including all of those sweetened preferences and the junior employees who are as interested in keeping their jobs as they are in the value of their options.

So why do all of these sweeteners exist? Well, lest it seem that I'm castigating evil investors, I think entrepreneurs have to take responsibility for the existence of sweeteners. They result from one of three circumstances:
1 - 3. Overfocus on valuation: Entrepreneurs measure their success in a capital raise primarily by the valuation they get. Investors respond to "valuation inflation" by adding sweeteners. Research shows that sweeteners occur more in boom times than in lean times. When tech is flying high, entrepreneurs convince themselves that they need a big "sticker price". VCs will give in but will insist on sweeteners that seem innocuous at the time but can end up destroying the company. In my view, the smart entrepreneur takes a lower valuation and keeps everyone's interests aligned.
4. Ignorance of implications: We'll assume that managers are all properly advised by their counsel as to the mechanics of these structures. But even that doesn't mean that managers are thinking through all of the implications. Remove rose colored glasses, replace with gimlet eye and do the math on various scenarios / outcomes and the implications will literally jump off the page.
5. Desperation: There is a 3rd alternative and while it sounds the worst, it's at least the most honorable. If, as a manager, you have a situation where there's only one capital source and they know it, you may not have much of a choice. Still, my advice would be to trade down on valuation as far as possible (I'll write later on anti-dilution issues which could come into play here) and minimize the sweeteners. It's painful, but a lower value tends to clean the slate, clarify everyone's situation and allow the company to develop organically as it should.

HGTV & Lowes Cross the Chasm

As you might have noticed the sub-title of this blog is, "The Collision of Commerce & Media". The premise - even three years ago - was that the boundaries between advertising and editorial were falling due to the de facto incursion of manufacturers and retailers into the world of media, primarily through the existence of their websites.

This evolution - arguably revolution - has been obscured by the larger enthusiasm over "social media" but it hasn't been lost on companies like Scripps, who I believe tried to stem the tide through initiatives like owning their own home shopping network & getting into merchandising. Unfortunately, at least of those initiatives were unsuccessful and so there's been an uncomfortable peace where a kraftfoods.com can be a reasonable competitor to Food Networks' websites and one finds oneself in the situation where your advertisers are also your competitors. In other words, yet another factor conspiring against and eroding traditional media's business model.

Which is why I think it's great news to see a deal like the one described in AdAge today where HGTV and Lowe's have gotten together. The most insightful quote to me was the one where John Dailey, HGTV's VP of Ad Sales bluntly acknowledged the reality: "They [Lowe's] view themselves as a media platform, safe to say, and, yes, we certainly do too." Kudos to Scripps for recognizing that and being willing to play it out.

PS - There's some subtext in the article about how the deal allows everyone to "talk to the consumer" more efficiently that's pretty weak (unless we're supposed to read 'talk AT the consumer'), but let's charitably chalk that up to all parties - including the reporter - being afraid to write an entire article without paying tribute to the forces of social media. But that's a story for another day.

Launching ‘Kitchen Table Conversations’ …a new research platform

Had a little hiatus from blogging, but I’m back with an exciting announcement! We’re launching a new product today. It’s a video research product that sits between the world of focus groups and ethnographies. The core of the product is that companies and agencies have been coming to us with research projects and we tap, on a demographically targeted basis, the appropriate members of our community who film themselves engaging in the behaviors the researchers are interested in & answering questions.

Here are a few examples of how we’ve been using it for JWT, AdAge, the National Retail Federation (NRF), Shop.org and others:

• Below is an embedded video of research supporting JWT and AdAge’s Rise of the Real Mom White Paper
• Client research on morning routines
• Two videos supporting JWT’s AnxietyIndex blog, one focused on general sentiments and the other on  the media’s impact  on people’s perceptions.

Based on these and other “trial use cases” we believe this is a disruptive technology that can ultimately change how qualitative research is done. In the meantime, we anticipate a lot of experimentation because it’s so affordable that ethnographers can use it as a precursor program to full ethnography studies and agencies can use it to support new client pitches without breaking the bank.

As a last note, I’d like to thank both Mark Truss at JWT and Earl Wilcox at Plannerzone. They both played critical roles in the ideation and evolution of the product. Earl will continue to be involved as an insights resource for clients who want that additional support & Mark we think will become one of the biggest clients of the service!

Here’s a link to our press release on the launch of Kitchen Table Conversations.