The Top 6 Startup Finance FAQ’s | Startup Finance Basics w/ Kruze's Scott Orn

Kruze COO, Scott Orn, joins Jason to dive into Finance Basics FAQs. (0s)

• This week's episode is part of the "Startup Basics" series, where experts share knowledge to help founders do things correctly, and all episodes can be found at thisweekinstartups.com/basics (9s).
• The series features top partners, service providers, accountants, legal and HR talent, and this episode's guest is Scott Orn, the COO of Kruze Consulting (26s).
• Kruze Consulting is a CPA firm that focuses on VC-backed startups and has many portfolio companies as clients, including Podcast AI, Superhuman, and Calendly (37s).
• Some of Kruze Consulting's clients, like Superhuman and Calendly, started with the firm and then graduated as they became big companies, and Kruze prefers to work with emerging startups (45s).
• The discussion will cover some of the most common founder startup questions, starting with how to avoid paying payroll tax (1m4s).

How can I avoid paying payroll tax as a startup founder? (1m5s)

• As a startup founder, it's essential to understand that avoiding payroll taxes is not a viable option, and the IRS has measures in place to prevent this, so it's crucial to focus on building the company rather than trying to avoid taxes (1m7s).
• One common misconception is that founders can avoid payroll taxes by being contractors to their own company, but the IRS will likely flag this as an attempt to avoid paying payroll taxes, leading to penalties and fines (1m50s).
• Paying employees in cash, such as $10.99, is also a mistake, as it can lead to employees claiming they thought taxes were being withheld, and the company may be held liable for paying those taxes (2m19s).
• In some jurisdictions, tax boards may demand that companies pay taxes on behalf of employees, even if the company has done everything correctly, and fighting this can be costly (2m37s).
• The government wants people to pay their taxes and not use 1099 forms to avoid paying payroll taxes, as everyone needs to contribute, and the solution is simple: sign up with a payroll company that automates payroll tax payments (3m19s).
• Payroll companies can automatically take payroll taxes out of employee checks and send them to the government, making it easy to comply with tax laws (3m31s).
• If a company receives an audit from the IRS on payroll taxes, it's often better to pay the fine and sign up with a payroll company rather than challenging the audit, which can lead to a review of all payroll records over the past five years (4m1s).
• When hiring a freelancer who has their own company and works on a project for over 6 weeks, it is acceptable to pay their LLC without withholding taxes as long as it's an arm's-length transaction and they are not considered an employee, such as in the case of a web development agency (4m23s).
• To determine if someone is a contractor or an employee, there are certain criteria to consider, including whether they work their own hours, use their own equipment, and have their own company, and if they are only working for one company and being told when to show up, they may be considered an employee (5m14s).
• The classification of a worker as a contractor or employee is state-based and federally based, and there can be interpretation, so it's recommended to work with a professional if the situation is unclear (5m49s).
• The employment situation in the United States is binary, with workers being either full-time employees or contractors, and there is no middle ground, such as a contractor who contributes to taxes and healthcare after working a certain number of hours (6m17s).
• Companies like Uber, Lyft, and DoorDash have had to deal with the classification of their workers and have had to negotiate with lawmakers and lobbyists, but for most businesses, it's recommended to just withhold taxes unless the entire business is predicated on using contractors (5m57s).
• Payroll companies are sophisticated and can provide expert advice on how to classify workers and handle payroll, and it's recommended to use one of these companies to ensure compliance with laws and regulations (6m49s).

How do you shut down a startup? (6m54s)

• The process for officially shutting down a company typically takes a month to three months and involves trying to sell the company, finding a home for the team and technology, and exhausting all options before closing down, as investors want to see that everything was tried before shutting down, and this can impact future funding for the founder's next company (6m54s).
• Founders should be transparent with investors about the reasons for shutting down and provide a narrative of what was tried and why it didn't work out, as this can help maintain a good relationship with investors and make it more likely for them to invest in the founder's next company (7m42s).
• When shutting down a company, assets such as laptops, equipment, and domain names are sold, and any remaining funds go to shareholders, with the last note holders being the first to receive any money (8m6s).
• If there is a convertible note, the remaining funds will go to the note holders, and if there is any money left, it will go to the seed round investors, but it is unlikely that any money will trickle down to the seed round (8m12s).
• Founders should remember to do their final tax return and final Delaware Franchise Tax, and let Delaware know that the company is shutting down to avoid any future issues with the state (8m45s).
• It is also important to have enough cash to pay employees' pay time off (PTO) before shutting down the company, as directors and officers are personally liable for PTO, and venture capitalists will often ask about PTO when a company is running out of money (9m30s).
• When it comes to accrued vacation time, it is considered earned and must be paid out if the company shuts down or the employee leaves, regardless of the reason for their departure (10m13s).
• Awarding vacation days instead of accruing them can help avoid building up a liability on the company's books, as accrued days can add up quickly if an employee leaves the company shortly after joining (10m50s).
• Founders should consider the impact of their company's success or failure on their employees, many of whom may have families or mortgages and are relying on the company for financial stability (11m1s).
• Helping the company get sold can provide a safety net for employees, allowing them to find new employment even if it's only for a short period of time (11m5s).
• Many founders go on to start multiple companies, with later ventures often being more successful due to the lessons learned from previous experiences (11m18s).
• Founders should prioritize maintaining a positive relationship with their team and investors, as these relationships can be crucial for future success (11m29s).

Why do I owe Delaware $50,000 in franchise taxes? (11m33s)

• Delaware franchise taxes can sometimes result in a $50,000 bill, causing panic among startup founders, but this amount can often be significantly reduced by recalculating the tax using the correct method (11m35s).
• Delaware has multiple methods for calculating franchise taxes, and the default method used on their website is often the most expensive one, resulting in higher tax bills (11m47s).
• To reduce the franchise tax bill, startup founders need to know their share count and total assets, which can be entered into the Delaware franchise tax payment portal to recalculate the tax (11m56s).
• Recalculating the tax using the correct method can reduce the bill from $50,000 or more to a significantly lower amount, such as $600, $2,000, or $3,000 (12m3s).
• Even law firms may not be aware of this trick, and their associates may send emails stating the higher tax amount due to lack of knowledge or experience (12m28s).
• It is essential for startup founders to remain calm and not panic when receiving a high franchise tax bill, and instead, look for resources such as blog posts or videos that explain the correct method for calculating the tax (12m20s).
• To avoid unnecessary stress, startup founders should take a moment to enter the required data into the Delaware franchise tax payment portal, recalculate the tax, and wait for the updated amount, which can result in significant savings (12m47s).

I’ve got my first customer lined up! How do I get paid? (12m58s)

• When a startup secures its first customer, the first step is to ensure the customer has signed a contract, ideally using a templatized document provided by a law firm such as Wilson Sonsini, Fenwick, or Goodwin. (13m13s)
• After securing the signed contract, the startup should invoice the customer, with the goal of collecting as much payment upfront as possible, as this is considered the cheapest form of capital. (13m45s)
• The invoice should give the customer 30 days to pay, and the startup should aim to negotiate prepayment, which can help with cash flow. (14m4s)
• When the payment is received, the startup will need to perform accounting, recognizing some of the revenue upfront and deferring the rest, depending on the services provided. (14m11s)
• If a discount is given to the customer, the startup should negotiate for payment upfront and include cancellation terms, such as 90 days' notice, to protect itself. (14m43s)
• Startups can use various platforms, such as Stripe or QuickBooks, to manage invoicing and payments, and should be aware of the difference between accrual-based and cash-based accounting, as venture capitalists prefer accrual-based accounting. (15m21s)
• Accrual-based accounting recognizes revenue over the period of service provision, whereas cash-based accounting recognizes revenue when payment is received, and startups should be prepared to provide both sets of numbers to investors. (15m59s)

Can I tell VCs that implementation revenue is ARR? (16m26s)

• It is not a good idea to tell VCs that implementation revenue is ARR, as it misrepresents forward-looking financials and can hurt credibility with investors (16m47s).
• Implementation or pilot revenue should be represented separately, such as on a second line, to provide a clear and accurate picture of the company's financials (17m10s).
• Misrepresenting revenue can be considered securities fraud, which can have serious consequences, including the loss of investor trust and potential lawsuits (17m54s).
• Investors may request their money back or sue the company if they discover that the information presented during fundraising was inaccurate or misleading (18m21s).
• A real-life example is given of a company that had to refund an investor $50,000 after the investor discovered that the company had made false claims during fundraising (18m47s).
• It is essential to be transparent and accurate when presenting financial information to investors, and to keep different revenue streams separate to avoid any potential issues (19m47s).
• Non-recurring revenue, such as revenue from building a website, should be treated as a separate line item and not included in ARR (19m38s).
• Keeping different revenue streams separate is crucial to maintaining credibility and avoiding potential problems with investors (19m50s).

Should I raise venture debt when I raise my Series A? (19m59s)

• Venture debt can be a cheap insurance policy, but it's often considered too late by founders and is not a solution to save a struggling company (20m14s).
• It's recommended to put venture debt in place during a round A or B, but not draw it down immediately, to have the optionality of drawing it down in the future (20m38s).
• Venture debt can go wrong when a company with 6 to 9 months of cash, facing trouble, tries to get a loan to save the company, but lenders can sniff out these situations and may call the company's investors (20m51s).
• Lenders are experienced and know the investors, making it difficult to deceive them, and they take their investments seriously (21m9s).
• Adding too much venture debt and using it as runway can be a big mistake, and it's recommended to use it as a rainy day fund instead (21m35s).
• If a company raises a $10 million series A and is offered a $3 million line of credit, it may not be worth the 1% origination fee, and it's better to have a small amount or no venture debt at all (21m46s).
• Venture debt lenders are not angel investors and take their investments seriously, and if things go wrong, they can be brutal and demand warrants or foreclosure documents (22m15s).
• Overleveraging can be dangerous, and series B investors may not want to give money to a company that has to pay back a lender from a previous round (22m56s).
• Venture debt is only recommended for insurance purposes if a company is doing well, and it's not a solution for mediocre or bad companies (23m14s).
• Scott Orn is a consultant who helps startups with their finances, particularly those with two or three people, and can be reached through Kruze Consulting at kruzeconsulting.com (23m40s).
• Doing chores, such as accounting, legal, and HR tasks, is essential for startups to maintain good discipline and hygiene, and it's crucial to get these tasks right (23m57s).
• These tasks are not areas where creativity is needed, but rather require a serious and buttoned-up approach, and doing them correctly makes life easier for startups (24m29s).
• Scott Orn emphasizes the importance of doing these tasks correctly, using the phrase "tight is right" to convey the need for accuracy and attention to detail (24m15s).
• Startups can be creative in areas such as design and UX, but not in accounting, legal, or HR, which are regulated and serious pursuits (24m22s).
• Working with a consultant like Scott Orn can help startups get their finances in order and provide valuable guidance and expertise (24m41s).