Podcast: Life Cycle of a Technology Company: Episode 1
Jim Bourke, Withum Partner and Technology Services Group Practice Leader and Chris DeMayo, Partner and Startup and Emerging Growth Team Leader, discuss the birth of a tech company, from entity selection to choosing the right accounting system.
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Speaker 1: Thank you for joining us for this segment with them sounding board, practical audio based information for today’s on the go professional production of Withum Smith and Brown PC.
Speaker 2: I am Jim Bourke practice leader of the technology niche here at Withum Smith and Brown and I’m here with Chris DeMayo team leader of the startup and emerging growth technology group within the technology niche here at Withum. Today we’re going to talk about the life cycle of a technology company. Everything from birth to realizing the exit plan. So here at Withum, we’ve put together a series of podcasts consisting of three podcasts, the breakdown, that life cycle of a technology company. You can listen to three independently or you can listen to the entire series where you hear Chris DeMayo and I go through the entire life cycle or birth to exit of a technology company. The first section of our series, the first part of our series, we’re going to be dealing with the birth of a technology company covering topics like entity selection and accounting system selection. So let’s talk about the birth of a tech company, Chris.
Speaker 2: And some of the issues that you and I see all the time off the top of my head, maybe entity selection. So you and I get called into a new tech company and inevitably the CEO has decided to choose an entity type may have done it online himself or herself may have used an attorney. So talk about, let’s talk about some of the mistakes maybe that we see as a result of maybe some of the CEOs making an entity selection without talking to their accounting or tax professional first. Yeah, you know, Jim, I think it’s a really interesting topic because I think it’s an example of at the very inception of accompanying one of the first decisions that a founder or an owner will make that can have a dramatic impact on the future. And oftentimes it’s a decision made alone and sometimes they will consult and sometimes they won’t.
Speaker 2: And it’s important to think through whether you want to be typically an LLC or a C corporation or potentially an S corporation. And I think it all really comes down to what you see the company doing in the near future. Who’s going to be financing that company and how they’re going to be financed. So if you’re gonna bootstrap the company and you’re gonna put your own money in, then you know an LLC is not a bad way to go cause you can get some tax benefits by doing it. Uh, but if you see yourself getting outside money, you know, whether it’s an investor, an angel, or maybe even a venture capital firm or a PE firm putting money into the company, you may want to be careful about choosing an LLC on the onset. You may want to think about a C corporation because you know, Delaware C corporations are sort of the tried and true model that most institutional investors like.
Speaker 2: And if you go with an LLC, you could potentially put yourself into a little bit of a tough situation where you know, you could potentially create losses in an LLC that wind up flowing into the hands of shareholders that can’t take those losses. Yeah, absolutely. So think about that. So the LLC generally speaking, is the path of least resistance for entrepreneur starting a company, right? It’s easy to form an LLC could do with disregarded entities, single member LLC, piece of cake format doodle online. But you’re right, you’ve got to think about the future, you know, will you have employees? Okay, so the question comes up if you’re going to have employees, many ways that companies attract and retain employees is they give them ownership interest. Now, not that it’s difficult to give an ownership interest in an LLC because we clearly work with clients that do that, but it becomes a challenge, right?
Speaker 2: It becomes a challenge because maybe those employees are not expecting pass through losses, you know, things like that on their personal tax returns. Not only that, let’s suppose that that entrepreneur is looking to take the company to the next level. You know, if I’m a VC, you know, they eventually get down to round and I’m a VC. Well you know what, I don’t want the same type of stock that you have. I want certain preferential rights. Right? So the ability to create different classes of stock, you know, so you talk about a C Corp, you talk about a Delaware C Corp, I couldn’t agree with you more. That tends to be the best path for those entrepreneurs that are visionaries that say, you know what, I want to exist three to five years. And, and that pathway to my success is bringing in other sources of capital.
Speaker 2: Yeah. Right. And I think, I think to that point, when you’re making that decision today, a lot of times you’re trying to make a decision thinking about future investors who you don’t know today, right? I mean you don’t know who those events investors are going to be. You don’t know how they’re going to invest. You don’t know what profile they’re going to have. And a lot of times when you go with a Delaware C Corp, it’s a relatively safe play because it’s a vehicle that everybody’s comfortable in. Everybody knows how they work. There’s, there’s tried and true litigation behind it for hundreds of years on the legal side. But you know, from a structure perspective, a lot of people are very comfortable with it. You know, as, as we all know right now, convertible debt is a very, very hot instrument in the investment world. When you can’t agree on a valuation very early on in a company, everybody agrees, all right, you know what?
Speaker 2: Instead of placing a value on a company and buying stock, I’m going to put some debt into the company and one day when we can all agree on a valuation or when you raise money in the future, that’s when we’ll convert our debt into stock. That scenario, which happens all the time can be a nightmare scenario if you are an LLC. Because what winds up happening is these investors put money into the company but they don’t own any stock. So all of the losses that are derived from the money that they’re putting in go into the hands of shareholders who can’t take those losses because they didn’t put any money into the company. And you know, you’re going to that point, you know, you and I know that those, those owners can’t take those losses because they have no basis. Right? But how many of them are doing their own tax returns on TurboTax and things like that and are taking those losses.
Speaker 2: I’ll give you a perfect example. We just, we were engaged by an LLC recently. We came in and all the employees are all owners in the LLC and we were asked to do some of the returns for some of the owner employees. And we started looking at some of their tax returns. And we realized that a number of these guys ended up erroneously taking losses because they appeared on their K-1s. They didn’t realize they weren’t entitled to those losses. So yeah, it becomes a challenge, you know. And with that comes the issue of, you know, we can move into professional selecting the right professional that understands the tech marketplace. You know, all too often to manure selects a professional that’s a generalist. You know, we’re all CPAs out there. We’re doing tax returns, we’re doing financials and you know, that’s what we’re trying to do.
Speaker 2: However, there are very few professionals that really know the specific tech sector. So maybe talk a little bit about the importance of choosing the right professional team when an entrepreneur starts a business. Yeah, I think it’s fantastic point. And on multiple disciplines, whether it’s, you know, accounting and tax, whether it’s legal, whether it’s bookkeeping, an outsourced accounting, you know, technology is a nuanced industry and there’s a lot of things that happen in a technology industry on a routine basis that you never really see in other industries. So if you’re a technology company, almost by default you have complex equity, you’ve got stock options, you may have warrants, you may be giving multiple levels of stock out and you may have complex revenue recognition issues. You may have. All of these things are relatively, you know, in the context of the entire economic spectrum unique. So if you go with a generalist, they may never see these things may, they may only see them once in a blue moon.
Speaker 2: And the benefit of going with an entity or an organization that really knows the tech sector is they deal with these things on a routine basis. And not only can they advise you on the instruments and the issues that you have, they can also make you aware of the things that you’re not thinking about. And that’s probably the biggest issue, right? Is understand knowing what you don’t know and being with somebody that already knows what you don’t know. So I think that, you know, a lot of times I kind of call a penny penny wise, pound foolish, right? Like you start, you start your company and you use your, your uncle’s accountant because he’s your uncle’s accountant and it’s just, and it’s just fine. But then one day, uh, you look back and say, wow, I wish I had better advice early on. I could agree with you more.
Speaker 2: I think about this. So you mentioned your uncle’s accountant. Many entrepreneurs start a business by, with friends and family. Inevitably somebody within County major, somebody prepares the return, someone’s doing the internal accounting and you know, very often we get involved in those relationships. And they don’t want to sever those relationships with those individuals, which is all good. So generally we’ll work with big companies and you know, it’s sort of a segregation of duties. We let the friends and family, you know, accountants or tax person, you know, do their deal with the same time. Now we’re adding our professional advice. We’re looking at many of the issues facing tech companies. I can’t tell you how often I go into a tech company, sit down, we win the client over, it’s all great. We pick up the tax returns and I’m looking at the returns and let’s say it’s a, say it’s a SAS solution provider or a company that has developed source code and they’ve taken no made, no attempt at an R and D credit or things like that.
Speaker 2: It’s because not that their accountant or tax payer didn’t do a good job, but they just weren’t well versed in the issues facing the specific industry. And I think you’re right when you think about it, another great example is it’s not a matter of finding the mistakes on the return. It’s a matter of knowing the things that aren’t there. We look at qualified small business stock and so many of our founders have an whole this concept of qualified small business stock. It’s often called QSB SBS. And what’s amazing about QSB S that many people don’t know that if you hold qualified small business stock, when you sell your company, you’ll either pay very, very depressed tax rates on it, significantly lower than current rates or in some scenarios in many scenarios you could actually have zero tax on the sale of your stock saving people millions of dollars. Q SBS is something in the technology world that’s very prevalent and known amongst technology accountants.
Speaker 2: But if you have sort of a standard run of the mill accountant, that may be a generalist, they may have never heard of that concept. Yeah, agreed. So you know the accountant is one, one aspect of it, you know, I advise all our tech companies surround yourselves with the right professionals. You and I are out there in space, so we see, let’s talk about the legal side. We know there are attorneys out there just like there are accounts out there, attorneys that specialize in tech, they know the issues surrounding intellectual property, they know the issues surrounding, you know, acquisitions in Goodwill and trademarks at protecting the company every which way that that’s humanly possible from a tech perspective. So again, not, it’s not just accounts, it’s also selecting the right attorney. And you know, very often tech companies make a mistake by not surrounding themselves, the right professionals on my opinion, the right professionals can be by the company side as they work down that road towards the realizing their exit plan.
Speaker 2: Yeah, absolutely. I think we have the right professional. It’s the kind of kind of organization that you could have from cradle to IPO. You don’t look huge. The cradle to the grave is scenario, but cradle the IPO, you don’t want to be in a position where you’re outgrowing your professional. And and to that point, I often talk to my clients about the benefit of having a professional in this space is also just the volume of transactions that they see. So you should be able to ask your professional what are you seeing in the industry right now? And if you’re with somebody that’s in the space, they can tell you, Hey, I’ve seen, I’ve seen 10 you know, banking agreements in the last year, I’ve seen a hundred, you know, incentive, stock option agreements. And here’s what I’m typically seeing right now in the industry. Yeah, true, true value of aligning yourself with the professional that’s in the space.
Speaker 2: And you and I know it’s a small community, we’ll go into let’s say the New York marketplace or the Boston marketplace or whatever marketplace we’re is currently hot in tech. All the players know each other, right? So you know, names resonate out there of the thought leaders in the space. And that’s the value about being with vault leader. They can also recommend other thought leaders in the space. So let’s make a transition now let’s talk about internal accounting. At many of our startup tech clients and our technology clients. So looking at selecting accounting systems, there are lots of systems out there, right? So you and I probably, what’s the most prevalent system you see a lot of our startup companies selecting? Yeah, I think it’s fascinating lifestyle. And when you look at the, you know, internal accounting for a startup and emerging growth company. So I think when you look at companies that are just getting started, there are two logical choices.
Speaker 2: One being QuickBooks, oftentimes it’s QuickBooks online, and then the other one being zero, which both are cloud based solutions. What’s nice about them is they’re sort of plug and play, right? You can, you can buy it and immediately you, you know, you link up your bank accounts to it and immediately you’ve got an accounting system capturing your data. You know, I consider it like stupid simple, right? Whether it’s zero or QBO, QuickBooks online. The other advantage is that it allows us to collaborate very easily with our clients. You know, like many of our tech clients, they built their model in a tech space in the cloud from the ground up. You know, both of these two models are cloud-based ground up and very collaborative with their clients. I mean most of our sort of clients, you know, we don’t necessarily have to go out to see them.
Speaker 2: We ended up keeping the fees to a minimum, right? Because you know, that’s what it’s all about in a startup, protecting capital, not spending a tremendous amount of money on the professional side. But again, getting the best professional advice. This is one way to do it. Not having our people go out there, do accounting, do write up work, but having a client entered a day to day operations, the receipts, the disbursements, having a relationship either with an outside payroll service where payroll leasing company and they recording all of those transactions in a zero or QBO or something that’s similar to that. And the advantage is giving us the login information and allowing us to collaborate very easily and really help them to understand the financial metrics that are coming out of their systems. Right. And they make a lot of sense. And what’s interesting about these specific solutions are it’s not just for really small businesses.
Speaker 2: There are plenty of companies that we work with. I’ve got $20- $30 million companies using into with QuickBooks, you know, so happy, very happy. And you know, years ago that wasn’t the case. But today you know many of these systems, because of the nature of our client’s business, because of, you know, you think about it today, it’s all a let’s say open API APIs and basically what what’s happening is our clients are going out getting best of breed, maybe front end systems processing sales transactions. In many of our internet based companies or SAS solution providers, they process a large number of small transactions with a lot of credit card information. And a lot of times, you know, those of these two entities, zeros, QBO, there’s plugins, there’s other vendors that have ideal solutions. So it extends the life of a QuickBooks where in the past, maybe companies were going with programs like dynamics or NetSuite or you know, any of the other higher end type solutions.
Speaker 2: But there’s definitely a place in the marketplace for both of these solutions. And I think, I think the most important thing is knowing to get on them early, but then also knowing the right time that it is time to transition. Exactly. Certain industries within tech, you, you have a long life span with QuickBooks or zero in other industries that are short. Yeah, you’re right. So you look at, for example, consumer products, e-commerce, you’re gonna have a shorter life span because you’re going to have a very high volume of transactions. You have to manage inventory, front end and backend. You may want a full integrated solution in one system and that’s, that’s a matter of talking to your accounts and understanding when’s the right time to come off when it, when does it become unmanageable and then when it is time to come off, what are the right solutions to get onto?
Speaker 2: Right. So the advantage of that is making sure you’re, you shouldn’t be talking to your accountant once a year, you know, tax planning time, tax season. It goes way beyond that. You know, you and I have great relationships with our clients. We’re meeting with them. We’re having lunch with them, we’re having dinners with them. We’re just stopping in. I make it a point to stop in and just say, hello. Hey, how are things going? As long as we’ve got our finger on the pulse of our clients, we’re able to help advise them about things like that. When is the next time to move to the next system? Thank you for listening to this piece of the podcast, dealing with technology companies, the lifecycle of technology companies. For more information and more content, which includes white papers and information, allow you to subscribe to our newsletter. Come visit us at withum.com
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