Editor Profile - Denny K Miu is the Founder and former CEO of two companies, Gigamon Systems and Integrated Micromachines (now Touchdown Technologies). Denny has extensive experience in developing technology, products and business relationships. He has been a Professor, an engineer, an entrepreneur, a team leader as well as an individual contributor.
Denny is currently the Executive Editor of LoveMyTool.com, his third start-up. You can follow him on Google Buzz or subscribe to his RSS feed.
When I first started teaching at UCLA, I had the good fortune of sharing a tiny office for ten days with a Professor Emeritus who was finally on his way to permanent retirement. Joe had officially retired twenty years ago but intellectually he was still very active (writing books and advising students). He kept a very low profile and was more or less ignored by the rest of the Department. Even the secretaries didn’t know his name.
Once he retired as a Professor, Joe was no longer a voting member of the academic senate and therefore could not champion anyone’s promotion. He told me that was when he found out how few friends he had in the Department. In retrospect, this was also the beginning of my nine-year journey to fully appreciate Henry Kissinger’s comment that “the reason why there are so much politics in academia is because the stake is so low.”
Joe and I got to know each other really well in those two weeks. We shared a small wooden desk (I would transfer my stuff from cardboard boxes into an empty drawer the minute that he finished vacuuming it out) and we would walk across campus to have lunch every day (but only to the student cafeteria, Joe hated the Faculty Club). Joe was as old as dirt and was the only person I knew (then and now) who survived concentration camp during the Holocaust.
Joe was like an older brother to me (even though he was the same age as my grandfather), taught me everything he could think of about surviving in academia. In particular, I loved his jokes. They were not only funny but were insightful and also full of wisdoms.
The one I still think about almost daily is the one about a Monk, a Priest, and a Rabbi, who gathered together to talk about religion and finance, and how they resolve arguments …
First came the Monk who simply said, “Material is immaterial to us. Every year we take the offerings and we throw them up in the sky. They land where they land and the poor will find them somehow. It is Karma, no argument is ever necessary.”
Then the Priest said, “I wish it was that simple for us. We have expenses, pillows for the worshipers, stained glass windows, flour for our bakery, etc. So we have a system. Every year we do financial projections. We calculate how much money the Church needs and how much we can afford to give away to the poor. Based on that, we draw a circle of a precise radius and we throw the money up in the sky. What lands inside the circle goes to the treasury and what lands outside goes to the needy. It is a wonderful system, eliminating many arguments.”
Finally the Rabbi spoke, “We believe in the wisdom of the Almighty. We take our money and throw it up in the sky. What God wants, he keeps. What he doesn’t, we keep. We never had any argument.”
And that in a nutshell summarizes the myth and reality of bootstrapping entrepreneurship.
Bootstrapping entrepreneurs do startups because we want to make money.
Whoever says that it is about “making meaning” has obviously never missed a payroll.
Like Mao said, “A revolution is not a dinner party, or writing an essay, or painting a picture, or doing embroidery.” Entrepreneurship is about the new violently overthrowing the old and it is never an abstract exercise. In doing what we do and asking others to follow, entrepreneurs affect people’s life and the life of their families. And we affect them profoundly. Not only do people get hurt, but we are constantly reminded that at the end of the day, no amount of meaning can replace money when it comes to buying grocery and paying medical bills.
I was not always this practical. Once upon a time, I was turned down by a VC (one of many) and years later when I caught up with him, I asked him why. His answer was remarkably simple. He said I had told him that I personally didn’t care about making money, that I was in it to build a great company and to bring good to society. So he figured if I didn’t care about MY money, then chances are that I wouldn’t care about HIS money. So why should he invest (he obviously did not remember my eloquent speech about making meaning).
Since then I have learned that building a successful startup requires the perfect alignment of many people’s diverse interests and desires. To motivate people, we need to understand what drives them. People are driven by many things: money, fame, power and destiny. The last one is particularly powerful which Steve Jobs understood well when he asked John Sculley if he would join him in changing the World or if he would rather spend the rest of his life “selling sugar water.”
I have learned that an entrepreneur’s never ending job is to align moving vectors. To succeed, we must figure out what rocks our hearts, our minds and our souls, providing our constituents with what they need and what they want. So clearly helping others make meaning is an important part of our repertoire.
But as the company grows and as more and more people are brought together, I have learned that the only thing that everyone has in common would be money. So my experience is that from the beginning, as an entrepreneur, we must focus entirely on making money and when we are successful in making money, we will be making meaning as well (because it is so damn obvious). But if we focus on making meaning, chances are that we won't make any money and even if we do, everyone would still argue over what meaning is.
Therefore as entrepreneurs, not only must we focus on making money, we must focus on making money for ourselves. Only when we care about OUR money, would others entrust us with THEIR money (and their sacrifices). And this is not rocket science. Like the Rabbi, when it comes to money, we should simply trust that everyone would be smart enough to figure out what they want. What they don’t want, we keep. And we keep as much as we can.
So this chapter is about making money and to bring home the point, about how to financially structure a startup such that we can make the most amount of money. And I try to answer the first question first which is “Should we form a C-Corp, S-Corp, or LLC? Which one is best for bootstrapping entrepreneurs, netting us with the most amount of money to take home (to our family) while giving us adequate protection and maximum flexibility?”
There is good money and not-so-good money.
As entrepreneurs, it is important to remind ourselves that like cholesterol, there are two kinds of money. There is one kind of money that is generated when we create “value” and then there is another kind that is generated when we create “valuation”. But unlike cholesterol, the distinction here is not necessarily between good and bad but between good and appropriate.
Any money that is generated from operations is good money. I live by the old saying that “Every unexpected problem in a startup can be resolved with the timely arrival of a PO.” Getting a purchase order and delivering the goods should be everyone’s focus and should be discussed and celebrated at the top of every company gathering.
To quote yet another well-known communist, “It is glorious to get rich.” It is glorious because making money from operations means our customers have finally validated that our products or our services provide intrinsic values, so much so that they are willing to pay for them at a price higher than our cost to provide them. There is no better meaning than this in making meaning.
It is also important to remind ourselves that Gross Margin is not profit and as a startup, we should never apologize for high gross margin (not even to our customers). If it costs 10 cents to build something that the customers are willing to pay a dollar for, then we have created 90 cents of values. In a startup, what quickly eats up the 90 cents is R&D. The higher the gross margin, the more we can afford to reinvest in R&D and the higher the value that we can ultimately provide to our customers.
On the other hand, entrepreneurs can generate money by selling part of their company to investors (i.e., raising equity money from VC’s). What makes an entrepreneur a bootstrapping entrepreneur is our realistic view of what value VC money could bring. We should never demonize VC money as much as we should never romanticize VC money.
Some bootstrapping entrepreneurs actually believe that we should never take VC money. I believe differently. I don’t believe VC money is either good or bad. That’s a false choice. I believe as an entrepreneur we take VC money when it is appropriate and we don’t when it is not.
I have learned to live by a simple rule, what I call “Conservation of Single Malt”. If I don’t drink too much celebrating the closing a VC round, then I don’t need to drink too much commiserating when I find myself having to raise another one.
I would encourage all aspiring entrepreneurs to NEVER think of VC money as R&D money. Instead, bootstrapping means that we have to be the ones to provide all necessary resources for R&D by not taking salaries for months (if not years) and by not paying anyone else for months if not years (including early employees, vendors, lawyers and accountants) . By not taking salaries, we are essentially making pre-tax investment and by asking a few other co-founders to not take salaries, we are leveraging our investment many to one.
I have learned that the only way to bootstrap a company until we have a ready product is to invest our personal money (don’t ever borrow money from your parents or your friends, and never from your 401K). If you can’t afford to dip into your own pocket, and if you can’t find a few co-founders who could afford to dip into their own pockets, then you have no business calling yourselves bootstrapping entrepreneurs.
Life is brutal, especially that of an entrepreneur.
On the other hand, VC money is working capital and bootstrapping entrepreneurs approach VC’s when ALL we need is money.
And there is even the possibility that we might never need VC money because we can generate enough working capital from operations. And that would be great. But when we do accept VC money, we do it only once. We take enough money from VC’s to bring the company to profitability (sooner rather than later) and we treat the VC money as if it is the last money that we are ever going to need or to get. You have one shot and one shot only. To do otherwise would be irresponsible.
Unfortunately, there are a lot of myths surrounding entrepreneurship, much of which is from people who have never failed as entrepreneurs. Such myths distort the true values of VC money to entrepreneurs.
For example, we often hear people talk about how if we don’t take VC money, we would be stuck with a large slice of a small pie. But taking VC money means taking higher risk and you might end up with not just a small slice but a small slice of a non-existent pie.
I am all about keeping a moderate slice of a moderate pie.
Another example is how people always talk about if we don’t take VC money, we might be stuck with a life-style and not a “real” company. That’s just bull.
Why would I put up with the rejections, humiliations, and hostilities if it wasn't for the change of life-style.
In summary, it is important that we keep all of these in mind and in balance when we structure our startup. We need to think about how to maximize our net worth while leaving us with the most flexibility in case we need to later raise money from VC’s, in case we are ready to sell the company, and even in the unlikely case that we would take the company public.
Bootstrapping entrepreneurs’ instrument-of-choice is an LLC.
A lot have been written about LLC (Limited Liability Company) and how it is different from a S-Corp or a C-Corp. All it takes is couple of Google searches and some late night reading and you will know everything there is to know about the subject. Therefore, the following is not meant to be a replacement for such essential exercise and it is not even to dissuade you to from hiring an attorney. It is mainly to share my personal experience, which is that LLC is a much better instrument for starting a company than forming a corporation (from the standpoint of making mo' money for an entrepreneur).
LLC is an interesting hybrid between a corporation (S or C) and a partnership.
Legally LLC is not a corporation but more like a partnership. But it is an effective shield for limiting your personal liability the same way that a corporation would, yet at the same time, doesn’t require the declaration of a liability-bearing General Partner which is what you have to do with a Limited Liability Partnership (LLP).
Also, from the customer perspective, an LLC sounds a lot like a corporation so it doesn’t have the stigma that comes with an LLP (people think of dentists, doctors and lawyers when you present them a business card that says LLP). Just like LLP or a S-Corp, an LLC is not a taxable entity so losses and profits can flow directly to the partners (no double taxation).
On the other hand, unlike an S-Corp, the profit and loss can be distributed anyway that is agreeable to the partners and not necessary according to the percentage ownership, which is very convenient. Also, LLC has no limitation on foreign ownership or ownership by another corporation (until it became AT&T again, Cingular was a LLC jointly owned by SBC and BellSouth).
All it takes to form a LLC is an operating agreement, which is not even a legal document and does not need to be filed. So you don’t need a lawyer to do what is basically common sense and can be done in plain English. So be sure you spell out the ownership structure of the LLC (there is no reason why it has to be equal among the founding partners but there is no reason why it cannot be, so whatever is agreeable to all partners is fine).
But be sure to spell out the circumstances when a particular partner is deemed non-contributing and therefore can be invited out by the rest of the partnership. Also, spell out what happens to his/her shares if any partner was to resign, to be terminated (with and without clause), incapacitated or death (either work-related or not).
So a typical solution is to give everyone four years to vest. Everyone must agree that any unvested shares can be repurchased by the remaining partners at the original price. Also, make sure that everyone agrees to a right-of-first-refusal and a co-sale arrangement so that if one partner decides to sell his/her vested shares, everyone else has the right to either buy the shares or to sell part of their own vested shares to the same buyer at the same time.
Furthermore, make sure you put a price on the shares so that everyone writes a check and buy the shares outright (which can be very low so that the total is on the order of a few hundred dollars). This is very important because once the stock is purchased, you have started the clock for capital gain. Keep in mind that these are 1244 stock which means that if you keep them for five years (which you most certainly would since that’s how long it would take to build a company if not more), then only half of your capital gain is taxable.
There are other benefits as well but the most important one is that if you ever leave your own startup, you can walk away with property that you already owned and you don’t have to worry about Alternate Minimum Tax (AMT), which would kick in if you exercise your still worthless options but there is paper gain.
On the other hand, for working capital, ask everyone to put in the cash as an interest-bearing loans so that when the company starts making profits, you can get the money back without any tax consequence.
Also, even as a LLC, you can elect to file your tax return as a S-Corp. This is important. The IRS has stipulated that any gain from a LLC (for active members) is considered personal income and therefore subjected to 15.3% self-employment tax. However, the laws are well established for the much older S-Corp in that you can pay everyone a nominal stipend (which is subject to self-employment tax), but then at the end of the year, you can declare any residual gain as dividend, which is not subject to self-employment tax.
Finally, if you ever need to take VC money, they will want to bring in their own high-paying lawyers and they will want you to form a C-Corp (in Delaware). By then, you can do a tax-free transfer between assets of the LLC and shares of the new company. The VC’s are going to put a vesting schedule on your new shares, which you will need to negotiate. But hopefully by then you have some leverage (like customers and profitability) and you can negotiate from a position of strength.
Finally, when you become successful as an entrepreneur, you will find that taxation will become your biggest cost item. The worst case scenario is that the government wants 15.3% for self-employment tax, 35% for Federal, 9.3% for State (of California) and 8.75% sales tax on any money that is left over that you want to spend. That’s a whopping 68%. If you are serious about maximizing your net worth and intellectually honest about making money for yourself and everyone else, there is no better place to start than here.
An an old friend once told me, "Everyone will eventually become a conservative, but they must have something to conserve first."
In conclusion, truth be told, I am still the same person that I was fifteen years ago when the VC turned me down. Personally I still don't care much about money and I am in it to build great companies and to bring good to society. But I have learned is that what I want as an individual is irrelevant. As an entrepreneur, we must accept responsibility. To truly make meaning, we must start by making money. And we must start by focusing on making money for ourselves and our families. Only then will we earn credibility with our employees and our shareholders who rely on us to make their money.
Good luck.
--Denny--
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