Conversation with a startup lawyer about startup studios: structuring and taxation
I recorded an online interview with Jared Verzello, a startup lawyer and founder at Presidio Legal, P.C. We discussed many legal aspects regarding starting and running a startup studio: choosing the right state, structuring the studio, taxation, IP ownership, and equity division. I was surprised to learn that in the USA, you may pay no capital gains taxes at all if you’ve held qualified small business stock (QSBS) for at least five years. I believe details like that are crucial to know before starting any kind of business. And there are many of the in this interview!
Watch the full interview on YouTube, or read this article based on the discussion.
Disclaimer: The information provided in this article is based on an interview with a startup lawyer and is intended for general informational purposes only. It is not legal advice. Consult with a qualified legal professional for specific legal guidance tailored to your situation. The author and publisher are not liable for any actions taken based on the information in this article.
From Cooley to Presidio Legal: Jared Verzello’s journey in startup law
I’m Jared Verzello, the founder and president of Presidio Legal, a law firm focused on the representation of venture-backed companies and venture investors.
My career began in San Francisco at a large law firm called Cooley. After gaining experience there, I joined a hybrid startup law firm, Atrium. I took Atrium through Y Combinator in 2018, and went through as a Y Combinator founder. Atrium didn’t work out, and we had to shut it down after two years.
In the aftermath of Atrium, I started Presidio Legal three years ago. Today, we have about 300 venture-backed startup clients and work with approximately 30 venture funds. We also provide assistance to a range of individuals, including startup studio founders, accelerators, incubators, and other entities involved in the startup ecosystem.
Startup studios: balancing investment and expertise
💡 What is a startup studio? Often referred to as a venture studio or venture builder, these entities share many similarities. This model is: a startup studio typically begins with a core team that generates and validates ideas. Once an idea has been validated, they attract co-founders to these new startups. Resources are commonly shared among the various startups in their portfolio. Moreover, a startup studio might attract investments to launch new startups, which in turn could attract external investments. In such a setup, the startup studio usually retains a share in these startups, typically around 20–30%. They attract co-founders who are dedicated to working solely on these startups. There could be two possible ways for a startup studio to attract investment. The first is an investment in the startup studio itself, and the second is specifically in the special startups that they have incubated.
Some of our readers might just be entering this industry and might need a more foundational understanding first.
When we talk about startup studios, we’re talking about people who want to build companies that have the potential to grow quickly and can eventually be sold. Occasionally, these companies may go public and list on public exchanges, but most will find a buyer and sell their company generally after 5 to 8 years.
So, the key players in this ecosystem are the founders and investors. Founders or entrepreneurs come in with the idea. They’re the ones rolling up their sleeves, building the company, the products, and finding customers. On the other hand, investors provide the capital to help these businesses grow, particularly in the early days before they generated significant revenue. This is a model that many of us are familiar with.
What makes a startup studio particularly interesting is that it does both of those roles. And because it’s a hybrid role, as a startup studio founder, it’s important to understand what are your relative strengths and whether you are going to lean more towards the founder side or more towards the investor side. Or are you going to potentially be just exactly in the middle and have a 50/50 split?
If you’re a founder of a startup studio or aspire to be one, how do you determine where you fit into this ecosystem and where you stand on the spectrum of founders versus investors?
In my view, there are two key considerations if you’re contemplating this role, or if you’re already in it:
- Capital allocation. Cash that you can provide to these businesses.
- Skills or sweat equity. Perhaps you don’t have a lot of spare cash, but you have something valuable to contribute to these various projects. This contribution could justify your stake in the company, potentially around 20–30% or more, depending on the services you provide and your level of involvement.
So, do you have access to capital, or are you primarily a skills-based, sweat equity participant? Understanding this will help you find your place within this unique ecosystem.
Structuring a startup studio. LLCs or C-corps?
The possible ways to structure a startup studio could include these forms: LLCs and C-corps.
To illustrate, let’s consider a scenario where you’re a startup studio with three different projects. Your unique strength is online marketing, which can be applied to diverse businesses.
Let’s say that you have a direct-to-consumer product, a unique pillow that you sell online. Your second project could be a fintech app offering user benefits. And your third project could be B2B software. All these businesses are different, yet all can leverage your marketing skills.
Ultimately, the goal is to sell each of these individual businesses. Even if only one business is successful and sold, that’s a significant achievement. For instance, if your pillow business thrives and attracts a buyer, it’s a win for your startup studio.
Let’s consider that the pillow business is sold for $300 million. The question then is, where does that $300 million go? The distribution of this sum is determined by the pillow business’s cap table, meaning the list of its owners. The startup studio will own a part of this business, as might other investors and employees. Let’s assume that the startup studio owns 25% of the business. That means the studio is entitled to $75 million from the sale.
Now, the startup studio itself has owners. These individuals would then share the $75 million. The aim here is to distribute this sum to the owners and investors of the startup studio in the most tax-efficient way. It’s not about tax evasion, but rather tax optimization — ensuring we pay the taxes we owe without paying unnecessary taxes.
In most startup studios that I’ve worked with, the studio itself is typically structured as a pass-through entity, often referred to as an LLC. LLCs and corporations are different structures that dictate how the entity is governed, who can make decisions, and who gets to decide when to sell the business or take on debt.
💡 A Limited Liability Company (LLC) is a legal business entity that provides limited liability protection to its owners, known as members. It combines the characteristics of both a corporation and a partnership.
These are not tax classifications, but governance structures.
Every created entity must elect a tax classification. This choice is between having the entity itself responsible for taxes or opting for a pass-through structure where all profits or losses flow directly to the holders.
Imagine the situation where the pillow business sells for $300 million and the startup studio gets $75 million. As an owner of the startup studio, you wouldn’t want the studio to pay taxes and then distribute the remaining money to you, only for you to pay taxes again. Instead, you’d prefer to receive your share directly (say, $7.5 million if you own 10% of the startup studio) and then pay taxes based on your personal situation.
Most often, startup studios are formed as pass-through entities or LLCs to avoid double taxation.
However, the individual operating companies are usually formed as corporations. The structure heavily depends on the nature of the investors. Institutional investors like venture capital funds generally do not invest in pass-through entities, which puts us in a bit of a predicament. If the startup studio is providing capital and needs to fundraise, the pass-through structure may not work well because it needs to attract investors who typically don’t invest in LLCs.
So, the strategy must be chosen based on where the startup studio stands in terms of sweat equity and capital. If the studio is primarily providing capital, a pass-through entity at the startup studio level might not be the best strategy due to the limitations in attracting institutional investors.
Most startup studios provide significant sweat equity, such as marketing expertise or development resources, to help their businesses gain traction quickly. This is typically how they secure their equity. Any capital they put in is often modest. Once these individual businesses start showing promise, they can attract investor capital.
The startup studio incubates the companies, validates the concept, and then often finds institutional investors to invest substantial sums once the business has been de-risked. This process requires a balance between the startup studio’s strategy and the strategies of the individual operating companies.
There isn’t a one-size-fits-all structure for startup studios; it depends on their fundraising strategy. If investors are funding the startup studio, it may not be feasible to form it as an LLC. But if investors are interested in investing in individual portfolio companies that show potential, the startup studio can probably form an LLC, allowing for tax savings at the top level.
The role of startup studio founders
Startup studio founders usually bring a lot of sweat equity or unique skills to the table, rather than large capital injections. If they had significant capital to invest, they would likely function more like a venture capital fund than a startup studio.
For example, Y Combinator, a well-known accelerator, provides coaching and connects startups to their investor network, but they do not engage in day-to-day operations. They are primarily financial partners who provide capital and access to their network. But startup studios are often deeply involved in their projects, playing a co-founder role.
Startup studios typically take a more significant equity stake in their projects, often up to 40%, reflecting their hands-on engagement and co-founder responsibilities. In contrast, accelerators like Y Combinator or Techstars take less equity, generally around 7–10%, as they do not engage in the projects to the same extent as a startup studio.
Navigating investor interest: Building credibility for your startup studio
Attracting investment to an LLC (like a startup studio) is dependent on factors similar to those for any startup, primarily revolving around the track record and credibility of the founders.
If founders have a history of successful ventures or have managed substantial investments well, they may find it easier to attract initial investments for their startup studio. The studio’s investment thesis or unique focus, which leverages the founders’ unique skills or insights, also plays a vital role. For example, a founder with extensive experience in social media and influencer marketing might create a startup studio focused on direct-to-consumer products leveraging influencer marketing.
However, not everyone has such a track record. These individuals may need to bootstrap their startup studio or seek initial funding from friends and family. They will then need to demonstrate traction, such as successfully launching and developing companies, to attract further investment.
Raising capital for a startup studio, like for any early-stage company, involves demonstrating consistent, significant growth over time. The key metric for measuring this growth may vary, depending on the type of business. For instance, a social media app might focus on new user signups, while a B2B software company might emphasize revenue growth.
A typical growth target for startups is 20% month-over-month growth for at least six months.
Investors are often more interested in this growth rate rather than absolute numbers, as consistent growth indicates a promising trajectory for the business.
In the case of a startup studio, the challenge lies in demonstrating the studio’s ability to launch and grow multiple projects simultaneously. The studio’s pitch to investors is not about any single project but rather about the studio’s capacity to identify new opportunities and ensure its success. This means that the studio must show early-stage traction for multiple projects.
However, achieving such traction takes time. From idea to execution, it may take months or even a year to establish a new business and demonstrate consistent growth over half a year. This is not unlike the trajectory of any other startup; success often comes after long periods of hard work, largely unnoticed by the public.
Investors tend to favor businesses that show a proven ability to execute and grow, rather than those that merely present promising ideas. This is especially true for founders who lack a history of successful ventures. Therefore, startup studio founders without such a track record must be prepared to “grind it out” to prove their ability to execute and generate growth.
Deal structures for startup studios
When a startup studio decides to onboard an investor, the structure of the deal will largely depend on the type of investor involved. Unlike corporations that typically offer stock options or restricted stock, startup studios — which are often set up as LLCs — can employ a “profits interest” model when dealing with their initial investors.
These early investors are typically high-net-worth individuals or family offices, who have the flexibility to invest in LLCs. Institutional investors, such as venture capital firms, are more likely to invest directly in individual businesses and might be less inclined to invest in an LLC.
In a “profits interest” arrangement, the investor receives a share of future profits that exceed a certain threshold or “hurdle.” This hurdle is set at the current value of the startup studio’s portfolio. For instance, if the startup studio’s holdings are valued at $12 million, this amount would be set as the hurdle. An investor who contributes $2 million for a 10% profits interest would start seeing returns only once the startup studio’s portfolio value exceeds the $12 million hurdle. The profits beyond the hurdle are then divided according to the profits interest agreement, with the investor receiving their agreed-upon share.
This model is particularly beneficial for the original founders of the startup studio. It allows them to retain the value they’ve built while offering investors a piece of the future growth potential. The profits interest arrangement can also be appealing to investors who prefer a more passive role, as they don’t hold any voting shares or membership interests in the startup studio. They have a share of the economic upside without getting involved in the studio’s decision-making processes.
However, some investors might desire more influence over the studio’s operations and decisions. In such cases, it might be more appropriate to sell them a direct stake in the business, similar to a traditional investment in a company. For instance, if the startup studio is valued at $12 million but is demonstrating rapid growth, the founders could decide to sell a 10% stake in the business to an investor at a $20 million valuation. This approach gives the investor a substantial ownership interest in the studio and the associated decision-making rights.
Equity for new hires in startup studios
When hiring talent, startup studios may offer profit interest as an incentive. This is especially true when recruiting talent that could otherwise join startups offering stock options. For instance, after raising funds at a $20 million valuation, the studio might offer a new hire a 1% profits interest with a $20 million hurdle. This doesn’t require the hire to invest cash upfront but aligns their interests with the company’s success.
However, it’s possible to offer new hires a chance to buy a direct stake, or for investors to receive a profits interest. Each scenario depends on specific circumstances and requires consultation with advisors to determine the best structure.
Choosing the right state for your startup studio LLC
Deciding where to establish an LLC for a startup studio depends primarily on the anticipated fundraising strategy.
For those intending to raise capital at the studio level, Delaware is typically preferred. The state’s legal uniformity simplifies portfolio management for investors, making Delaware a popular choice for businesses nationwide.
However, if you plan to fundraise separately for each portfolio company, forming an LLC in your home state may be more cost-effective, potentially saving you around $800 annually in filing fees.
For international founders, Delaware’s digital-friendly approach is highly advantageous:
- Its allowance for digital signatures and online filings greatly simplifies interactions with state bureaucracy, making it an appealing choice. However, U.S. residents should consider the additional cost of paying filing fees in both their home state and Delaware.
- Delaware also has a reputation for being a fundraising-friendly state, further enhancing its attractiveness. Given these factors, when choosing from the 50 states, Delaware stands out as a practical choice for its digital convenience and its alignment with investor preferences.
Wyoming is gaining some interest, particularly in the Web3 and crypto sectors. The state’s law is aiming to be more accommodating to these types of businesses, as traditional regulations often don’t fully capture their operational nuances. This makes Wyoming potentially appealing for startup studios centered around Web 3.
However, this trend is still in its early stages. While it’s an interesting development, it’s not yet a frequent occurrence in the fundraising landscape I encounter daily.
Timing for forming a subsidiary company: balancing costs and tax considerations. Qualifying for a $10M tax exception
When validating ideas in a startup studio, the question of when to form a separate C-corp subsidiary for each idea is crucial. It can be a balancing act between spending resources wisely and ensuring tax benefits in the future.
Although creating an entity as early as possible is generally better, it’s not economical to set up a C-corp for every idea you want to test. The process can cost around $1500-$2000, considering filing fees and legal advice, even for a streamlined, plain vanilla setup. So, spending this sum for 10 ideas, while only one evolves into a viable business, would be inefficient.
However, the eventual goal is to sell these businesses. If you hold stock in the business for at least a year before selling, you can benefit from long-term capital gains tax treatment in the U.S., which is usually more favorable than ordinary income tax rates.
For instance, you could be paying around 20% tax on the sale of a business, rather than 37.5% ordinary income tax. So, if you’re selling a business for, say, $7.5 million, the difference in tax rates can mean significant savings. Therefore, obtaining stock in these companies as soon as reasonably possible can offer more financial options down the line.
So, while it’s not necessary to set up a new company as soon as an idea emerges, it’s essential to consider the potential tax advantages when deciding on the right timing.
There are more intricate aspects to consider when deciding the timing to form a new entity, especially when looking at U.S. tax implications. Two key concepts come into play here: long-term capital gains tax and Qualified Small Business Stock (QSBS).
Firstly, when you hold an asset, such as stock, for at least a year, it qualifies for long-term capital gains tax which is usually lower than ordinary income tax. However, if that asset is a QSBS and you’ve held it for at least five years, the benefits are even greater.
QSBS is a type of stock in a company that meets specific criteria, including having less than $50 million in assets when the stock was issued. If your stock qualifies, the first $10 million you receive from selling it may be exempt from capital gains taxes.
So, in a hypothetical scenario where you’re a startup studio founder holding 10% of the studio, receiving $7.5 million from a $75 million sale, the tax implications differ significantly based on how long you’ve held the stock. If you’ve held it for less than a year, you may be subjected to taxes up to 37–38%. If you’ve held it for at least a year, this could drop to around 20%. But, if you’ve held a QSBS for at least five years, you could potentially pay zero capital gains taxes on the entire sum.
Therefore, you have to weigh the initial cost of setting up a new entity ($1500-$2000) against potential tax savings, which could run into millions if a business becomes successful. Success in this industry often requires an optimistic mindset that you can build a business worth hundreds of millions.
A reasonable approach might be to form a standalone entity once an idea has shown promising growth, say, 20% month-over-month growth in a key metric for six months. At this point, acquiring stock in the new entity can start the clock towards the five-year QSBS tax benefit, preparing you for the possibility of the business becoming a major success.
IP ownership and equity division in startup studios
When considering whether to first establish co-founders or a C-Corp for a startup studio, an essential factor to remember is the ownership of the intellectual property (IP). Regardless of the decision to incubate the idea within the startup studio or to form an independent subsidiary immediately, it’s critical to document that the IP being created is owned by an entity and that there’s a clear agreement on the equity ownership of the project.
In startup studios with a core group capable of launching and testing products, the necessary agreements would already be in place. The employees would have employment agreements with the startup studio, stipulating that the code they write or any other IP they create is owned by the startup studio or its individual companies. This clarity of IP ownership is vital, ensuring that no individual contributor claims personal ownership.
If the startup studio does all the work in-house, it’s feasible to incubate the project for a certain period before setting up a separate entity. Once the project shows promise and you’re ready to incur the cost of forming a new entity, the process is straightforward. The new company issues equity to the startup studio, and in return, the startup studio assigns all the IP (codebase, marketing material, domain names, etc.) to the new entity. In such cases, the startup studio may initially own a significant portion of the new company’s stock, given its total involvement in the project.
As the new company grows, it may need full-time team members or even a new co-founder. At this point, the startup studio-owned company can issue offer letters to potential candidates, offering them a stake in the business. However, throughout this process, the ownership of the project should always remain clear and documented.
In the context of a startup studio collaborating with external partners, it is paramount to ensure clarity regarding intellectual property (IP) ownership and equity division. These partners could range from ex-bankers for a fintech app to manufacturers for a product-based venture. Since these partners aren’t part of the startup studio and don’t have employment agreements, their contributions wouldn’t automatically fall under the startup studio’s IP.
In such scenarios, you could have these individuals sign a consulting agreement with the startup studio. The agreement would clarify that while the startup studio owns the IP, the partner would be entitled to a certain percentage of the equity when the project spins off into a separate business. This approach works well with startup founders open to such agreements.
Alternatively, for more established or traditional businesses, it could make sense to start a separate Delaware corporation from the outset. This way, they can be issued their stock upfront, and the paperwork would reflect the formality of the partnership.
In any case, it’s crucial to have clear documentation in place. People’s recollections can vary in the event of a dispute, and a lack of proper documentation can deter investors who view such situations as messy and risky. Consult with legal counsel to ensure all arrangements are documented correctly.
Remember, having proper documentation doesn’t always mean you need a new corporation for each project. While setting up a corporation may cost around $1500, it’s a worthwhile investment, particularly when third parties contribute significantly to the work product and own a substantial amount of equity.
The key consideration is whether your startup studio can consistently generate successful companies. If you’re not certain, it may be more cost-effective and simpler to start with one business. Once that business is successful, you can establish your startup studio and create more businesses under it. This approach is especially helpful if you’re bootstrapping or are new to starting businesses.
The role of SPVs in pooling funds for startup studio investments
SPVs, or Special Purpose Vehicles, are often used as investment vehicles to pool many small investors into one entity that then invests in a startup or LLC.
💡A Special Purpose Vehicles (SPV) is a legal entity that allows multiple investors to pool their capital and make an investment in a single company.
For example, a startup studio might have one large investor and 25 smaller investors. Instead of managing each small investor individually, an SPV (like a new LLC) is created. Each small investor buys their position in this LLC, which then invests as a single entity into the startup studio. This simplifies administration, as the startup studio only has to deal with one manager representing all the small investors. This model is used even at larger scales, with crowdfunding portals like Republic or Wefunder, to manage investments from thousands of individual retail investors.
SPVs are typically used as investment vehicles for pooling funds, especially in venture capital. For instance, a venture capital fund might set up an SPV to raise additional capital for an investment that exceeds its normal fund size. SPVs can be used for special investment opportunities, hence the name.
Subsidiaries, on the other hand, are businesses owned by another business. In a startup studio context, if the studio owns a significant share of another business, that business might be considered a subsidiary or a portfolio company, depending on the level of ownership and control. The term ‘subsidiary’ generally implies majority ownership, often accompanied by control. However, the distinction between a subsidiary and a portfolio company is more relevant for accounting purposes, such as in reporting consolidated financial statements and filing tax returns. In casual conversation, it’s more about whether the parent company has control over the other business.
Income and equity-related taxes for startup studio founders
Two key tax considerations exist for startup studio founders: income taxes and equity-related taxes.
Income taxes apply to wages drawn from the studio. These are based on where the founder lives and works. In the case of a multinational team, each founder pays taxes in their respective location. U.S. citizens or green card holders pay U.S. taxes regardless of their location, although taxes paid abroad can offset U.S. tax obligations.
Equity-related taxes apply when founders receive money from selling their equity. Founders want to ensure they’re taxed at capital gains rates, not ordinary income rates, and if possible, that they’re eligible for qualified small business stock benefits. These considerations are part of the setup process, and founders need to think ahead about their likely tax jurisdiction at the time of sale, to optimize their tax situation based on the rules of that jurisdiction.
Best of luck everyone! If you’re interested, you can find Jared’s contact information on his website presidio.legal. You can reach out to the info page there, and you can get connected to one of the attorneys, if this is something that you’re interested in — speaking to a legal advisor in more detail to talk about your specific situation.
