In the first of a two-part episode, we cover the most common concerns startup founders run into on startup formation, from our guest Mike Schulte, Principal and in-house legal expert at Great North Ventures who holds a JD/MBA from St. Thomas University.
Schulte at St. Thomas, covered the Healthcare IT sector as an MBA student manager for the Aristotle Fund. Next, he spent 20 mos as a Venture Associate at Soffer Charbonnet Law Group where he worked with clients of all sizes providing advise on legal matters ranging from offering memorandums for private placements to mergers & acquisitions. Mike has led legal and actively contributed to investing since joining Great North Ventures in January of 2018.
In this episode, we talk about picking a name, choosing between an LLC and a C-corp for incorporating your company, and the benefits of 1202 Qualified Small Business Stock.
Who does Schulte see executing? Brian Schoenborn at Moss & Barnett & David Winkler at Koley Jessen.
The second part of this two-part episode will cover fundraising, board structure, and more.
Transcript:
00:09
Welcome to the execution is King podcast where we talk to successful startup founders, investors and ecosystem builders to uncover insights and best practices for the next generation of great global startups. I’m your host, Joseph Siebert. I’m with my co host, as always Rob Weber. And he’s a partner at Great North ventures. Hey, Rob, how you doing today?
00:31
I’m doing great. How are you doing? Joseph?
00:33
I’m doing pretty well. I’m excited for this guest. You know, we get all kinds of inbound questions from founders. When you’re dealing in early stage, you run the gamut of entrepreneur requests, right from people sitting in their garage with an idea to people who have actually taken million dollars in funding and had previous exits and are thinking about doing something to people or raising like their Series A. So it’s really, really great to have this guest on today. Rob, you know, maybe you can speak a little bit more to like, why exactly, we’re bringing them on? Well, I
01:06
think being a founder of early stage company, you really have to be more of a generalist. And that means you need to understand across the kind of gamut of the different functional skills just enough so they can get your business off the ground. So you got to know a little bit about legal, a little bit about operations, a bit about sales, a bit about marketing, a little bit about technology, design, all these things finance counting
01:31
just enough to be dangerous, right? Yeah, that’s
01:33
right. And I know when I was 20, I started my first I call it my first real company, I had some like tinkering projects as a teenager on E commerce and startups. But having never scaled a business before. On the legal side, we made a few mistakes. And we’ll probably talk about some of those in this episode. But it’s not, you don’t really notice those mistakes when you’re getting going because they don’t really hurt you. But then as you start scaling, the amount of like I like leave, you know, sometimes you’re talking about technical debt, you can have legal debt, too, if you’re not setting up your business the right way. Or if you’re not raising money with the right terms, things can come back and bite you. And so what we’re going to do with our colleague, Mike here, is tried to share some of that wisdom, so that for founders, you don’t make those mistakes that others like myself have made. And we can save you a huge amount of headaches down the road by just paying attention to some of this knowledge that is gonna be shared with you.
02:31
Before we welcome our guest on, we just need to put up a disclaimer that today you’re going to hear a lot of legal accounting, finance and tax stories, right things that we’ve done. But none of this is to be taken as advice, because it’s so particular to your individual situation, that if you need advice on this, go to an advisor. We’re just sharing the stories about what we face today. So our guest today is Mike Sheltie. He is principal at Great North ventures. Welcome to the show, Mike. And Joe.
03:05
Hey, hey, Rob. Excited to be here. I’ve been listening to the show for a while. And I’ve always wanted to be a guest.
03:12
Mike, why don’t you start by telling us a little bit about your background and experience?
03:16
Yeah, sure. So I actually get the question a lot of how did I end up at a at a VC fund. And I think that that journey is a little bit different for everyone. Mine’s not too uncommon. But I started out as a lawyer, and I didn’t practice law for too long. I went to law school in Minneapolis at University of St. Thomas, where I got my JD MBA, and I kind of the whole time knew I wanted to work with investment funds. Although I was at the time I was thinking real estate funds just because that’s kind of the world I came up in. And that’s what I was interested in at the time. So I started practicing at the small law firm in Minneapolis. And it was a great experience because I got to work with a ton of different types of clients. And what I found out is I loved working with the entrepreneur clients, the ones who are building businesses, scaling businesses, and these were businesses of all types. So some of them are family businesses where they’re trying to figure out how to hand that off. Some of them are startups that are just launching their first internet company and one of them is actually it was actually a legacy business that was providing services to produce farmers in California but he took advantage of, of the changing cannabis laws and started servicing cannabis farmer clients and that was actually a really interesting business to work for for a couple year period and ended up going really well for him. What I really liked Working with these entrepreneurs of all types, I got to see a lot of stuff. What I didn’t like, was the business of law, you talk with a lot of lawyers. And it’s the same story every time. It’s a very tough business to run, even though the work is very interesting. So I decided I wanted to jump to a different position, it gave me an opportunity to work more on the value creation side. At about that same time, I saw great North ventures was just launching their first fund. So I called up Robin Ryan, and we had our first conversation. And shortly after that, I was working with great North ventures as their first analyst hire, and then with them ever since. And now I’m a principal fund,
05:44
we’re really lucky that you made that decision and fortunate to have you on the team is incredibly valuable to have you as a part of the team. And I think, you know, what I think about that client service model that a law firm has, I could, I think I would feel the same way as you were probably back then Mike, where it was, you know, I think about, you know, it’s like the hourly bill rate grind. And this like, it’s not even about, it’s not so much about the value created, it’s about maximizing how much you can bill, oftentimes, I feel like not even just to rip on lawyers, but like just service providers, in general, it’s just like, so many of them get it wrong, where they don’t focus on the value, they focus on just, it feels like they’re not in, they’re not trying to complete things or complete things in a way that maximizes value. They’re just trying to build as much as they can, when you find the rare service providers, if you want to think of it broadly. And I’m, by the way, we’re a venture capitalist, we’re also a service provider. Now, when you find the rare service provider that actually focuses on value and things like an entrepreneur, it’s like gold. And that’s why I think it’s like, really, you know, Mike’s been just a huge addition to our team, from really, very early on, we were very fortunate to this kind of our past is crossed, and it was perfect timing. So really excited. Yeah,
06:55
you’re absolutely right. And even in my role at Great North ventures, I’m, I’m working with a lot of service providers, as you know, and it is I love the service providers that we work with, and we continue to try to work with them as much as possible. Because when you find one that’s good, that’s actually creating value and not just trying to build ours by being a practitioner. That’s you need to hold on to those people because they can help you.
07:23
Mike, can you share alike, specifically what you do at Great North ventures now?
07:28
Yeah, that’s actually a really hard question to answer, Joe, because anybody who’s ever worked on a VC fund knows that you do a lot. But one thing that I do a lot of fund operations, and legal and finance, to do a lot of that side transaction management. So every deal that we do, I’m really leading the transaction, whether it’s from the legal diligence side, whether it’s from structuring the deal with the company’s attorneys, that that’s kind of where I’m at. And I want to say, since joining Great North labs, we have done 38 initial investments, and I can’t even count the number of follow on deals or the number of broken deals. Unfortunately, it just happens a lot in this business. But I’ve seen a lot of seed stage series, a stage venture capital deals. And at this point, I don’t feel like I’m running into stuff anymore that I haven’t seen in terms of deal dynamics and things that can throw a little wrench into a venture financing round.
08:36
So Mike, let’s start at the beginning here, when a startup is just starting to form, I mean, one of the first things they need to do is just pick a name, what are some of the considerations you think, with respect to picking a name that startups need to be mindful
08:51
of? Yeah, Rob, I actually get this question all the time. And I’m gonna I’m gonna be real honest, upfront. For most companies, I think this is not the best way to spend their time and resources. But nonetheless, a lot of them do need to pick a name. So I like to tell them where they can search for names and just come up with a list of potential names. I honestly don’t like when the spelling gets too funky, because then it’s hard for customers to find online. And we’ve all we’ve all had that issue. How do you spell this is a.io.com. So make it something that’s easy to find. But then just from a pure technical perspective, every state is going to be a little different, but you do need to incorporate in that state. And if you just do a quick Google search with say, for example, I do a lot of work in Minnesota, if you just type in Minnesota Secretary of State business filings. You will it will it will be one of the top Google results to get to that website. And then you can just type in your names and you can find out if there’s any other companies Has that are already incorporated under that name? So that’s how I would search.
10:06
Okay, so you find an available name. What do you do after that?
10:11
After that, I think you start building the company, I get a lot, a lot of questions about whether you should trademark it or not. And when we talk about trademarks, this is quite a bit more complicated than just finding a name that is available for your business. If you’re going to pursue trademark registration, you’re going to want to work with an attorney, it’s really not that expensive, there are some filing fees with the USPTO, you can try to do it yourself. But these applications, they’re, they’re kind of a beast. And then there’s usually a lot of back and forth with the examining attorney at the USPTO. And if you don’t know how to manage those communications, they can drag on for months. And that can take up a lot of time. So I highly recommend finding a small business attorney, it’s really not that difficult of a job for them to do. But they will get it done faster. I also don’t think it’s time to trademark any of your logos in any of your slogans or your business name, until you started to actually build up some brand awareness, there’s really not a whole lot of risk that somebody’s going to come in and infringe on your business name. Until you’ve gotten to that point, unless your business is something maybe like one 800 flowers, or cars.com, then maybe you have a better case for early trademark protection,
11:39
though it’s not a good strategy to just like say that your slogan is the best software company and trademark that
11:49
yet it’s not and honestly, Joe, unless you can prove that you actually are selling software, which a lot of startups, you know, they try to get these trademarks in there, like pre revenue, pre product stages, you can’t even get a trademark at that time. So it’s just a waste of time.
12:07
That reminds me of this great story. The Beatles used to have this drummer very early on named Pete Best. And sometime in the 60s, after the Beatles had found success, he released a solo album after leaving the Beatles around Christmas time called Best of The Beatles. He made a ton of money, right? And they tried to sue him for all this infringement. But they had no grounds because that was literally his name. He could prove, hey, this is my name. And I was from the Beatles. And yeah, that was a good workaround.
12:41
So maybe the answers to change your name to a well known person?
12:46
Yeah, my name, my name is Intel, Microsoft now.
12:52
Nice. I love it. I love it. You know, that’s part of being entrepreneurs being creative, right? So I think the so now you have this name picked out, you cleared it. Now you gotta go incorporate your company. Well, what do you founders need to be thinking about at that time?
13:07
So there’s typically two types of business entities that they can incorporate as there are more than just two. But there’s two main ones that most people are deciding between. That is the LLC, or the limited liability company, and a C Corp.
13:24
So how are those entities different? Like,
13:27
let’s actually first talk about how they’re similar because I think that’s, that’s the quicker one and then we’ll go into their differences. But they’re similar in the terms that they get, they provide us a shield of limited liability protection for the owners of the business. For the most part, I think that they both provide quality protection for the owners, a lot of founders I talked to think that they can just do anything, once they have this shield of limited liability. That is not the case. If you are acting in a way that is in bad faith or clearly breaking some rules, or you should know not to act that way. Customers or investors or partners in your business, they can sue you and they will try to sue you. So the best way to limit your liability for an entrepreneur is just to not act in a way that would make somebody want to sue you. That’s that’s the advice I usually give in terms of limited liability, because you can never completely eliminate your liability in these types of businesses. As an entrepreneur.
14:37
That’s actually my motto.
14:40
Don’t act in a way that people will want to sue you.
14:44
It’s done me well this far in life.
14:46
Well, thanks, Mike. I think this is incredibly important. When I was 20 years old. The first real business that I started out of the dorm rooms was it was called freeze.com at the time, but anyway that’s not really important. What’s important was I got back had advice, I set the business up as an LLC, I didn’t know any better, I’m coming out of the dorm rooms. And that business went on to scale from zero to 70 million in annual revenue and be profitable for 16 years and 170 employees. And that simple decision of being an LLC would go on to haunt me multiple occasions over the 16 years. And I’ll give you two or three examples. Number one, we were created a pass through effect, so that all the taxes became liable to me as an intern, or the other member ship unit holders. So we constantly were wrestling with the tax related consequences of that decision. And so we’d have to make tax distributions and just all this messy stuff. Secondly, and we were not running this to be a lifestyle business, we were running it to create venture scale from the beginning. And we wanted to have employee stock options, we can’t have stock options in an LLC, the closest you can do is this kind of weird substitute thing that lawyers have come up with called usually called, like equity, appreciation rights, or sometimes referred to as like phantom stock. And there’s all kinds of Yeah, profits interest, makes it incredibly more complicated. And then the third one, we didn’t really raise any money. So this one didn’t impact us, thankfully, much. But you also investors because of that pass through effect, if an investor has say a VC has 100 investors in their fund, by the nature of you being an LLC, you’re passing through all that income through all the funds investors, because it’s a pass through entity, and VCs is that does well, for most VCs, I think that might not be true for VCs that have all institutional money, because I think there might be but in any event without getting into detail, like that was my number one advice for a startup that is planning to create, like venture scale is just do not be an LLC. And if your lawyers telling you to do that, you might want to find another lawyer, right? That’s like my litmus test for lawyers that are providing bad advice is that they’re advising a startup to create an LLC, it’s like they that shows they don’t know what they’re really they’re doing right.
17:07
Yeah, Rob, I think you’re right. And I’ve you actually hit it on the head. And I’m kind of a tax nerd, I’m always shocked at how entrepreneurs aren’t aware of this distinction, because this is the big difference, when the rubber meets the road between the two entities is corporations that are double taxed. So that meaning the corporation, there’s a corporate tax rate on C corpse, I think it’s around 20% right now. And then they are the owners of the business are the shareholders, they’re not taxed on anything unless the business kicks out distributions to them. So if the business decides to take their profits, they pay the tax on those profits, they can reinvest that back into the business. However, if they do pay it out to the owners of the company, then those owners will pay personal income tax on those profits. That’s where the double tax comes in, the money gets taxed at the corporate level, and then it gets distributed to the owners and taxed again. Whereas LLCs, like you mentioned, Rob, pass through taxation, no matter whether you even if you reinvest the capital from or the profits from a business, and you don’t distribute it to the owners, the owner still have to pay the taxes on that income. That’s why you’re talking about having to do tax distribution so that the owners are able to cover that tax bill that they have from the products, the business.
18:39
And so maybe you said differently, or, you know, I think the reason most startups don’t really need to spend much time caring about that double taxation in a corporation is startups usually don’t want to make money. They want to take any profit margin that they’re generating or gross profit and just reinvested in their own growth. And oftentimes, they’re raising money because they want to run at a loss to keep fueling their growth. And so you don’t really that, that double taxation isn’t really an issue. So is that then when you would want an LLC is if you’re just building like a cash cow business that you’re gonna draw a lot of capital, you can get a little bit marginally better tax rate because of the bad effect.
19:18
Oh, actually, actually, where it’s tempting to be an LLC at the beginning for these tech startups, is because you’re right, they are in the first couple of years generating pretty big losses sometimes, so that they and not only do you pass through income from an LLC to its owners, you also pass through the losses. So let’s just use an example with a business and let’s say it generates a loss. Or let’s say there’s a founder who owns 100% of the business, and they pay themselves $100,000 a year salary. The business itself actually generates a lot I have $100,000. So that founder has personal ordinary income of $100,000, from his salary, but then he can write that down with the $100,000 loss to zero. So essentially, he’s paying no taxes, that’s $35,000, roughly, depending on his tax rate that goes straight back into his pocket. So if you try to tell a founder, that they should be a C Corp in those early stages, it makes sense to them to be an LLC. And then they’re thinking, Why should I be a C Corp, but that’s $35,000 that I potentially have to pay in taxes then. And in personal taxes, if they’re paying themselves that salary. However, there are certain other considerations, whereas a lot of times, it does make sense to be an LLC for business. But if you’re trying to raise capital from venture funds, or other investors, most VC funds or institutional investors, they are only going to invest in C Corp. So they are going to require that you convert to usually a Delaware C Corp. It can be it can be a C Corp in any other state, but it’s typically a Delaware C Corp. So if you’re, if you’re planning to create venture scale and raise venture financing, you’re going to eventually need to incorporate as as a C Corp, I do see some companies who want to take kind of who want to have have their cake and eat it too, where they’re an LLC, up until they raise venture financing, and then they convert to a C Corp. That’s absolutely a good approach. And that works. But you need to do it before you go out and raise venture capital, don’t try to do it in the middle of a financing round, it just throws another wrench into the deal that we’ve seen a lot can make a mess.
21:53
Mike, there was this other issue I had. Actually I didn’t discover this one until about, I don’t know, after about my first eight or 10 Exit events, I was just kind of I didn’t realize there’s something called qualified Small Business doc, and then section 202 of the tax code that can you know, help save you some money down the road in taxes, right? Can you kind of, you know, just talk about what that is? And, you know, how does that impact founders?
22:20
Yeah, I always talked about to when there’s a founder who doesn’t want to be a C Corp, they want to stay an LLC, so they can pass through losses to themselves. And what I tell them is, look, you’re you’re not going to get these great tax benefits from being an LLC up front. But on the back end, here’s what you can get. And we talked about 1202 qualified Small Business stock. Really, it’s a great rule to incentivize investment into startups. And there’s a few requirements to qualify as 1202. Q, SBS, it’s generally referred to as an acronym. And there’s a there’s a lot of requirements, but the big ones are that you need to be a C Corp. So the stock needs to be issued a primary issuance from a C Corp and a primary issuance means it’s new stock that the company is creating and selling, it’s not a secondary sale from somebody who already own stock in the company. Another requirement is you have to hold it for five years. So it’s the this rule is designed to create long term investment and startup so it has to be held for five years. And then the third big one is the company has to it has to be a small business, it has to be a startup type business. Luckily, most small businesses qualify because that threshold is actually 50 million and fixed assets. So no, none of the companies that we have invested in Great North ventures exceed that threshold at the time of our investment. So pretty easy to qualify if you know what you need to do.
24:03
So basically, if you’re investing in a startup, as an angel investor, you’ll meet these requirements, generally speaking, right?
24:12
It doesn’t work for real estate companies. A lot of people trying to do that. But it doesn’t refer to state companies.
24:18
What about for venture like, does it work for venture capital funds? Can they claim this credit or investors in venture capital funds? Can they claim the credit?
24:29
Absolutely. So without putting you guys all to sleep, a venture fund actually can claim this credit. And then the venture fund itself is not a C Corp. The Venture Fund is a pass through entity and they pass through this the tax benefit to their limited partners or their investors.
24:52
So Mike, what are the benefits of this Q SBS the 1202 qualified Small Business stock, the benefits
24:59
It can be huge. Let’s say you sell a company on year six, and you put that on that stock, let’s say your basis in the stock is $100,000, you invested $100,000 into a company or as a founder, your basis is going to be zero, most likely. And then you sell that stock for let’s call it $10 million. As a founder of businesses, you’re gonna have $10 million in capital gains long term capital gains that gets taxed at between 10 and 15%. For most, most people who are running startups, what the QS BS allows you to do is it allows you to exclude up to 100% of those capital gains, so you don’t need to pay any tax on those gains. And what this does is an incentivized founders to start businesses and funds and Angel investors to invest in them and grow businesses and create jobs. So the benefit is actually huge. If you just if you just run the math, if you’re the capital, if you let’s say you have capital gains of $10 million, that’s going to be between 100,000 Or sorry, 1 million and $2 million in taxable capital gains tax.
26:20
Yeah, thanks a lot, Mike. I think the for additional summary information I know you contributed to this post on the angel capital Association blog, so maybe we’ll put that in the show notes for those that want to really study up on this.
26:35
Yeah, I also want to throw out there because they are in Congress right now. They are trying to reduce this benefit from 100% exclusion to I think somewhere around 60 to 70%. Exclusion. Everybody, Google how to email your Senator, I, they are actually trying to reduce this 100% exclusion down to 60%. I’ve already mailed my senator and I encourage everyone to I think this is a win win for everyone to keep 1202 around as long as we can and to keep it as beneficial as we can. Because it works not just for investors, but also for entrepreneurs. So I do want to add because Rob, I know we have talked about this. How do entrepreneurs take advantage of this? And you want to talk to your attorneys up front and ask them about 1202 Ask them how do you qualify for 1202 stock because on exit, you don’t want to get hit with a huge tax bill. I know Rob’s probably got some horror stories about that.
27:41
Oh, man, I believe I’m a great American citizen in the eyes of the IRS, I paid a lot more than my fair share by not just setting things up the right way at the beginning. So
27:54
alright, thanks so much, Mike. This is a lot of stuff that we’ve covered here. You know, talking about naming and your entity and tax implications. We’re gonna have to have you on we’re gonna make this a two parter. Next episode. Let’s dive into fundraising. How does that sound to you? Are you willing to come back?
28:12
This is awesome. Yes, I’ll come back with let’s talk some more.
28:16
All right, our first ever two parter. We’ll see you next time on execution is king.
