Most startup companies are created by a small group of people commonly referred to as founders. These are usually the people who have the original ideas for the new business, the technical expertise to develop the new product or service and bring it to market, and the ability to contribute the capital (or find investors who will contribute capital) needed to launch the new company.

Founders often believe they don't need to worry about compensation, benefits and other employment law issues until the company starts generating revenue or profits. (They think that's when the company will finally hire its first "real" employees.) But founders should figure out their relationship with each other (and the company) at the very beginning of the venture.

Equity Split

The founders first need to decide how ownership of the business will be divided. Splitting the equity equally among the founders might be a tempting simple solution, but a smart startup will weigh a variety of factors to determine how ownership should be shared:

What are Startup Costs?

Startup costs are (1) the expenses a business incurs before it is actually operating plus (2) the cash the business will need to pay its recurring operating expenses during the post-launch period when it is generating insufficient cash flow to cover those payables.

A Good Business Plan Is Crucial

The founders of a new business should devote significant time and effort to the preparation of detailed business plan so that the startup costs are not underestimated. A miscalculation in this area can have a variety of bad consequences:

  • A delayed store opening or product launch

  • Last minute borrowing for startup expenses and working capital at high interest rates

  • An inability to hire enough staff

  • Angry investors who were expecting larger profits based on the inaccurate numbers

  • Unpaid vendors and consultants who withhold products and service deliverables

  • Founders trying to save money by adopting a do-it-yourself approach to business needs that should be outsourced to specialists (e.g., legal contracts, software implementation, trademark searching, logo design)

Tax Matters

Keep in mind that the expenses in this summary include more than just the "start-up" and "organizational" costs that the Internal Revenue Service permits a new business to deduct or amortize. The IRS's rules about startup costs are technical, complicated, and include various limitations. This summary is instead designed to give you a comprehensive real world picture of the resources you'll need to launch your new business without regard to their tax treatment.

Categories of Startup Costs

Startup costs fall into three categories:

  • Startup expenses: costs incurred before the business opens

  • Startup assets: assets acquired before the business opens

  • The cash you need on Day 1 to pay recurring operating expenses during the immediate post-launch period that can't be paid by the business' cash flow.

The exact mix of these categories (and the items within them) will differ depending on the type of business you're starting. E-commerce businesses will have different startup costs than brick-and-mortar ones. A manufacturing business will have different needs than a retail or service business.

Startup Expenses

Research/Training:

  • This is all the money you spend analyzing the feasibility of the ideas you have for your new venture. Examples: market and product research; trademark searches; the founders' travel and other expenses for attending trade shows and industry conferences; and the cost of any courses or workshops attended by the founders or employees before actual operations begin.

Legal:

These are the fees paid to lawyers and government entities to:

This category also includes filing fees for:

  • Corporate charters

  • Fictitious names

  • Business licenses

  • Tax registrations

  • Other permits and regulatory filings

If you're raising money from investors before launch, your lawyers will also be paid for drafting:

  • Private placement memos

  • Subscription agreements

  • Securities filings

  • Other seed money or venture capital documents

  • Negotiations with the investors

You may also want lawyers to take a look at your:

If you are borrowing money from a bank, there may also be legal fees to draft and negotiate loan documents before launch as a startup expense.

Depending on your business you may want your lawyers to apply for patents or trademark registrations prior to launch. Provisional patent applications and intent-to-use trademark applications can be particularly useful before operations begin. These startup expenses would consist of legal, filing and search fees paid prior to launch.

Finance

  • Opening a business bank account becomes and legal and operational necessity once your new entity is formed and obtains an EIN. Business bank accounts will typically require payment of a monthly service fee and additional per transaction fees if you exceed a certain volume of checks or deposits.

Branding:

  • This is your spending related to your business identity -- logo and initial website design, signage, business cards, stationery, packaging and brochures. The category is mostly fees paid to various designers and consultants, as well as printing companies.

Insurance:

  • Premiums paid before the launch date for property and liability insurance for your office, store, factory, warehouse, inventory and vehicles. Business interruption insurance premiums paid before launch would also qualify, as well as fees paid to insurance brokers and risk management consultants.

Payroll/Employee Benefits:

  • If you onboard employees or contractors pre-launch, the wages, salaries or fees paid to them (or withheld and paid to insurance companies and governmental entities as premiums and taxes) qualify as startup expenses. Any pre-launch workers' compensation and health insurance premiums you paid are also startup expenses.

Rent/Security Deposit:

  • Rent and security deposits paid prior to Day 1 are a startup expense, along with any utility charges paid pre-launch (electricity, phone service, water, gas). Don't forget utility deposits, parking fees or garage rent, and warehouse or storage fees.

Computers and office equipment:

  • Although these would usually be considered startup assets, a limited amount (around $100,000) can be deducted as expenses. Point-of-sale equipment for a retail business would qualify here.

Technology:

Typical fees incurred pre-launch are for:

  • Internet access

  • Website creation

  • Data hosting and storage

  • SSL Certificates

  • Payment gateways (for accepting payments online)

  • Email accounts

  • Email newsletter software

  • Tracking and onsite website analytics

  • Customer Relationship Management systems (CRMs)

  • Customer support software

  • Mobile app store fees (if creating a mobile application)

  • Payroll, Accounting, and document management software (or SAAS fees for those functions)

  • Any fees paid for custom software design and implementation and the cost of buying up domains.

Pre-Launch marketing/PR:

  • Advertising and marketing expenses, grand opening signs, the cost of investor and trade show presentations, and the fees and dues paid to join trade associations and industry groups.

Office supplies:

  • You need these on Day 1 so some will be purchased pre-launch: paper, pens, stationary, staplers, packaging, coffee, water, etc.

Consultants:

  • In addition to your lawyers and accountants, your startup may have paid for the services of other consultants for graphic design, IT, marketing, human resources, employee benefits, site acquisition, leasing, and insurance.

Borrowing Costs:

  • Startup expenses paid with bank financing or credit cards will presumably require interest payments before the launch date.

Miscellaneous:

  • Think of any other business-related expense paid prior to launch.

Startup Assets

Startup assets are the tangible things acquired for the business pre-launch, like furniture, equipment, machinery and land. The costs of these are depreciated over a period of years in accordance with IRS rules.

  • Starting inventory or raw materials

  • Other current assets (supplies and other small items that last less than a year but are still considered assets)

  • Office furniture/store fixtures

  • Signage

  • Leasehold improvements: expenses incurred prior to launch to renovate your business space (including lighting, paint, repaving the parking lot)

  • Plant, machinery and other equipment

  • Land

  • Vehicles

  • Other assets: intellectual property acquired prior to launch; office equipment and computers in excess of IRS expense allowances

Cash for Recurring Operating Expenses

These are the items that make up your monthly "burn rate," and most startups will need cash on Day 1 to pay these for 3-6 months.

  • Rent

  • Utilities

  • Web hosting, data storage, SAAS fees

  • Employee payroll and sales commissions

  • Inventory/Supplies

  • Marketing/Advertising

  • Taxes (other than those relating to payroll)

  • Interest payments on loans, bank account fees

  • Legal, accounting and other consulting fees; payments to other contractors

  • Other Expenses: Shipping/postage, maintenance, insurance premiums, etc.

If you are looking for more information on startups, you may be interested in learning about how to choose your business structure, how to do an equity split to distribute founder and employee stock, or how you can protect your intellectual property.

Support for Founders

If you need help estimating startup costs for your business plan or any other purpose, post your legal need on UpCounsel's marketplace. UpCounsel screens out 95 percent of lawyers to provide only the best lawyers from top law schools like Harvard Law School or Yale Law School. UpCounsel lawyers have an average of 14 years of experience and have provided legal services to companies such as Menlo Ventures, Airbnb and Google.

Which founders made (or currently make) the following contributions to the business?

  • The ideas for the new business

  • The initial or current business plan

  • The business's key intellectual property

  • Cash

Which founders will make the following future contributions to the business?

  • Time/work ("sweat equity")

  • Opportunity costs (which founders are making sacrifices by pursuing the new business?)

  • Industry expertise

Which founders need to be paid a salary immediately?

There is no right answer to the equity split issue, but asking the following questions will give your startup a solid basis to make a fair decision:

  • Who had the ideas?

  • Who will do the work?

  • Who has (or finds) the money?

Employee Equity

Most startups reserve some portion of their equity (typically 10 percent) for future non-founder employees, so the founders are really dividing the remaining 90 percent.

Vesting of Founders' Equity

Most startups require the founders' stock or LLC interests to vest over a period of three to four years rather than grant full ownership of the equity from the beginning. A typical four-year vesting arrangement would vest 25 percent of stock on the first anniversary of the initial grant (a so-called one-year cliff) and then vest the remaining shares quarterly or monthly over the next 12 quarters or 36 months. A vesting schedule motivates the founders to stick around for the long term and protects the company if a founder leaves prematurely (for example, a founder leaving after month 18 would own only 37.5 percent of her stock). Potential investors will also want to see the founders tied to a vesting schedule for the same reasons.

Founders' Agreement

Closely related to how the equity is split, the founders also need to decide the following:

How they will split the work

  • What functional roles and responsibilities will each founder have in the company?

  • Who will run the day-to-day operations?

  • Who will handle sales and finding new customers and clients?

  • Who will raise new money and manage banking and investor relationships?

  • Who will handle administrative details around employees, contractors, licensing and other legal compliance?

How they will make business decisions

  • Does every decision require all founders to agree?

  • Do some decisions require agreement from some founders but not others?

Although consensus may be ideal, any founding group with more than two people should give each founder the power to make certain decisions individually (in other words, each founder needs some scope of operating authority). A company where each founder can veto any business decision risks paralysis and endless disputes.

Obviously, major decisions involving the business (e.g., changing its products and services, bringing in new investors, signing major contracts, ending the business) should require the approval of more than one founder.

Intellectual Property Assignments

The startup will need an intellectual property assignment signed by each founder to transfer to the company all IP related to its business (or its products and services) that the founders created before the company was formed.

Your startup should engage a reputable business lawyer to draft the documents for the equity split, vesting schedule, founders' agreement and intellectual property transfers. Typically the company's shareholders' agreement or LLC operating agreement will include most of these provisions, along with buy-sell procedures that apply to the stock or LLC Interests if a founder is fired, quits or dies.

The Founders as Workers

Founders are often willing to manage and work for a startup without compensation for some period of time. The potential benefit of owning a significant chunk of the company's stock is usually considered more important than a salary.

Some founders, however, may need to earn a salary because of their personal financial circumstances. For example, a founder may not have enough accumulated savings or wealth to work without being paid or may not have any other source of income (like a spouse's job). Whether the founders want or need to be paid by the business right away, the company must decide to treat them either as employees or independent contractors and comply with the relevant legal requirements.

Employee vs. Independent Contractor

Employees are much more expensive for a business than contractors. Employees require all of the following:

  • Payment in cash of at least a legal minimum wage

  • Overtime pay if they are nonexempt under IRS Rules

  • Workers' compensation insurance

  • Legally required federal, state, and local tax and benefit plan withholding (and a payroll system to manage those payments)

  • A level of record keeping and regulatory compliance that a startup can find challenging from a financial and personnel standpoint.

Contractors are different. They simply provide services in exchange for fees or other compensation that the company pays without withholding taxes or contributions for benefit plans and insurance. In theory, contractors make their living providing services to other businesses and don't need the protection of the employee regulatory scheme. Contractors can agree to any legal form of compensation and they set their own hours.

Misclassification is even more tricky if the contractor later "converts" into an employee. If the job responsibilities don't significantly change, the IRS may consider the prior work as being performed by an employee and can fine you the company for the original misclassification. In some states these penalties can range from $5,000 to $15,000 for each violation.

If you consider the various factors the Internal Revenue Service, state law, and U.S. courts use to determine employee or contractor status, a founder providing services to a startup will (in most cases) be more correctly classified as an employee rather than a contractor.

As a general rule, classification is based on how much "control" the employer has over when, where, and how an employee works (including the duration of her workday). However, the exact standards differ from state to state and your startup should consult a local attorney for your specific situation.

Many companies, however, will decide to risk the potential fines and penalties because of the added expense and administrative burden of having employees from Day 1.

If your startup decides to treat the founders as independent contractors (at least initially), you'll need the following:

  • A service agreement with each contractor that describes in detail what she will do for the company; the compensation she will be paid; her confidentiality, non-disclosure and non-competition requirements obligations; and provisions transferring all intellectual property created by the contractor to the company

  • A Form W-9 from each U.S.-based contractor so that she properly reports the income on her tax return and the company can deduct her compensation as a business expense on its tax return.

If the company decides to treat some or all the founders as employees, the list of what the startup needs to do is significantly longer.

  • Obtain an employer identification number (EIN).

  • Provide notice to the relevant states' Department of Labor of the new hires.

  • Obtain workers' compensation insurance.

  • Obtain a Form I-9 and documentation from each employee confirming U.S. citizenship.

  • Obtain a Form W-4 from each employee to determine the withholding deductions from their wages.

  • Establish a payroll system (the IRS penalizes about 1 in 3 businesses for payroll mistakes) with a separate bank account to properly pay wages to the employees and manage all required federal, state and local withholding. (Engaging a payroll management service is recommended to comply with the technical rules that differ from state to state.)

  • Classify your employees as exempt or nonexempt and pay overtime as needed.

  • Comply with OSHA and Department of Labor health and safety requirements such as emergency action plan, exit routes, safe walking and working surfaces, medical and first aid supplies.

  • Create an employee file system for proper recordkeeping.

  • Create an offer letter for each employee summarizing employment terms.

  • Obtain confidentiality, non-disclosure, non-competition, non-solicitation and intellectual property agreements from each employee (can be contained in one document).

  • Establish a vacation, sick day, and holiday policy.

  • Post all legally required employment law disclosures in poster form

  • Create an employee handbook of company policies and practices such as sexual harassment prevention and equal employment opportunity.

Although not technically required to commence operations, consider how the company will eventually deal with the following issues when it has more than a few non-founder employees:

  • Health and retirement benefits, including a 401(k) plan.

  • Outlining the company's standards of business conduct and creating a method for addressing feedback, complaints, and other issues.

  • Maternity and paternity leave policies and other family-related benefits.

  • Employee performance reviews.

  • An employee equity plan.

Support for Founders

If you need help drafting the agreements among your startup's founders, determining their status as workers, or complying with employment-related legal and tax obligations, post your legal need on UpCounsel's marketplace. UpCounsel screens out 95 percent of lawyers to provide only the best lawyers from top law schools like Harvard Law School or Yale Law School. UpCounsel lawyers have an average of 14 years of experience and have provided legal services to companies such as Menlo Ventures, Airbnb and Google.