Fog Creek Software
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Approaching the Business Side

Joel,

How did you approach the business side of starting Fog Creek?

Did you work with a lawyer or accountant to decided on the company structure and other ownership issues (such as stock options for employees), or was it more evolutionary. How did you find the right professionals to work with?

I was surprised to read in this forum you chose a C-corp when everyone I know uses S or LLC.

-Brian

BrianM
Wednesday, February 25, 2004

The law firm that was recommended to us was big and famous and wanted a $30,000 retainer just to talk to us. There was a time during dotcom mania where you weren't someone unless your law firm was VLG or MoFo. I was literally told that you had to use VLG or maybe, distant second, MoFo, or I could never convince VCs to invest. "They won't take you seriously if you don't have a serious lawfirm." I snorted up my milk.

There was a time, I'm told, when both of these firms expected 1% share of the company, outright, before they would "accept" you as a client. Talk about hubris. By the time we got to them the hubris was worn off so the 1% was waived, but... come on, $30,000 retainer to start a company?

A "Joel on Software" reader had gone to work for a small firm (axiomlegal) that was more like a clearing house for independent-consultant type lawyers, so we used them, and they did all the initial paperwork for around $2500. Later I realized having a lawyer for this was overkill and I should have just used one of those Delaware mail-order-incorporation things. Once things get more complicated (e.g. when we want to start issuing stock options) we will need a real lawyer to reorganize everything, anyway.

I'm still happy we're a C Corp; that was the right decision because it allows you to have different classes of stock which you need to have to take outside investment; it allows you to have lots of shareholders; etc. etc. Basically we're a C corp for the same reason people install Windows Server 2003 on their laptops: it's the same codebase but with nothing disabled. When I was at Juno I remember them spending a fortune converting from an LLC to a C-Corp so they could go public and I wanted to avoid that. There's nothing wrong with C-Corps. The whole double taxation story is a bit of an urban legend.

Our accountant is mainly useful for corporate income taxes once a year, and for ongoing advice on rare occasion throughout the year. I can't remember how we found him, although he does work for American Express so I get frequent flyer miles when I pay his big ol' annual bill.

Joel Spolsky
Fog Creek Software
Thursday, February 26, 2004

" it allows you to have different classes of stock which you need to have to take outside investment;"

And you've been telling us you don't *want* VC money.  You dog!  You're just holding out for the BIG dollars, aren't you?  ;)

Norrick
Thursday, February 26, 2004

Ah, but it's the type of outside investment that's important here.  We've recently been approached by a larger company who may want stock as part of a deal we're doing with them.

VCs are the only people who are interested in a company's stock.

No-Vc Please
Thursday, February 26, 2004

Joel may not want to take VC or other investor money right now...but there might be some scenario in the future where he would accept outside investment.  Nothing wrong  with keeping one's options open...

Eric Bowersox
Thursday, February 26, 2004

Converting from LLC to C corp may be expensive but from S Corp it shouldn't be. Benefits of S Corp?

1) Medicare tax. You can escape that if you pass the income straight through rather than via a salary. It's ~1% I think so even if your salary isn't very high..it's still dinner at a nice restaurant. (ok, dinner isn't a good enough reason for the trouble)

2) Acquisition scenario. If someone wants to acquire your "assets" instead of your "stocks", the payment would pass to the corporation as income and out to the shareholders as dividends. What? Do you really think you can justify to uncle sam how your salary went from a hundred Ks to several million in one year? No my friend, dividends..double tax my friend.

If you really needed the stock classes of a C Corp, then you have no choice. If you don't need it, then perhaps you will want to re-consider.

Humbug
Friday, February 27, 2004

#2 is a good point. I can't remember if we thought about this in particular. Indeed people that want to acquire you usually want to acquire the assets and not the shares because then they can be sure they're not getting any invisible liabilities.

Joel Spolsky
Fog Creek Software
Friday, February 27, 2004

They will also want to acquire assets because they can depreciate it and use the "expense" to reduce tax burden on their income. Buying your stock is like an equity exchange. They give you post-tax profits for your stocks. May not matter to a very large buyer but something to consider. There's probably other options for the large buyer that I'm not aware of since I'm not an accountant. I recall from the book written by Frontpage's founder about how they went through 1 or 2 shell companies before they were officially Microsoft's property for tax reasons.

Humbug
Saturday, February 28, 2004

Also, converting from C Corp to S Corp is a pain in the butt..especially if you have built up equity since starting your C Corp. Consult your tax advisor carefully. If he's good, he should be giving you different scenarios with trade offs, etc. for you to pick from.

I found that lawyers have a different perspective on this however. They really like the flexibility of a C Corp. Get multiple opinions if you can. $30K however is QUITE an overkill.

Humbug
Saturday, February 28, 2004

Where you lose in a C corp vs. S corp is on earned income and retained earnings.  Your earned income is taxed.  If you want to distribute your retained earnings as part of an asset sale, those are dividends.

Most software companies (other than Microsoft) don't have a bunch of excess cash in the bank over liabilities.

You can structure a purchase (I've done it) where you buy the assets of a C corp only and have the stockholders convert their stock and therefore only pay capital gains.

Think about it for a second.  If you couldn't do this VC's would be screwed.  They always want a C corp.  They would have to pay double tax.  Believe me they don't.

If you are a seriously profitable software company without outside investment and plan to keep it that way go S (if you are that profitable you are an idiot for taking VC money anyway) otherwise C.

Philip Sugar
Wednesday, March 03, 2004

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