Lecture 18: Legal and Accounting Basics, with Kirsty Nathoo and Carolynn Levy

What this lecture covers

Kirsty Nathoo, CFO of Y Combinator, and Carolynn Levy, general counsel at Y Combinator, walk through the legal and accounting mechanics every startup founder needs to know: incorporation, equity allocation and vesting, fundraising paperwork, business expenses, and hiring and firing employees. It sits among the course's operational lectures, following talks on management, user research, and product design, and focuses on the unglamorous but consequential administrative side of running a company.

After watching, you should be able to explain why startups incorporate as Delaware corporations, what standard vesting means and why it matters even for solo founders, how unpriced fundraising rounds and valuation caps work, and what basic obligations founders have when paying themselves and their employees.

Key ideas

• Incorporate in Delaware, keep it standard: Delaware's settled corporate law and familiarity to investors make it the default choice; deviating (or converting incorrectly, as one example shows) can cost hundreds of thousands of dollars to fix.
• Founders are employees: a startup is a separate legal entity from its founders, and founders must be paid at least minimum wage rather than working for free, which is illegal.
• Equity should usually be close to equal among co-founders: because execution, not the original idea, creates value, and disproportionate splits are treated as a red flag for founder trust and alignment.
• Vesting protects everyone: the standard four-year vesting with a one-year cliff ensures a departing founder or early leaver does not keep a large stake they didn't earn, and it applies to solo founders too, since investors want to see commitment and it sets a cultural example for employees.
• Unpriced rounds use a valuation cap: instruments like safes or convertible notes let early investors convert into shares later at an upper-bound valuation, rewarding them for taking risk early, but founders must track how much future dilution this creates.
• Common investor requests to evaluate carefully: board seats, unofficial advisor roles, pro rata rights (the right to maintain ownership percentage in future rounds), and information rights all carry different tradeoffs for founders.
• Business expenses require a clean separation: company money must be spent on the company, not personal use, and receipts should be kept so a bookkeeper or CPA can prepare accurate tax returns.
• Employee classification and firing practices: correctly classifying someone as an employee or contractor affects tax withholding and IRS scrutiny, and firing should be done quickly, directly, with immediate payment of owed wages and accrued vacation, and with access to company systems cut off right away.

Walkthrough

Why and how to incorporate in Delaware (2:40)

Nathoo and Levy explain that forming a separate legal entity protects founders from personal liability, and that Delaware is the default choice because its corporate law is well established and familiar to investors. They illustrate the cost of deviating with a story about a company that mistakenly remained a Connecticut LLC for years, requiring four law firms and a $500,000 bill to fix during a fundraise.

Documents, equity allocation, and stock purchase agreements (5:36)

The lecture covers the paperwork that follows incorporation (bylaws, board formation, IP assignment) and stresses keeping signed documents organized. It then explains why founder equity should generally be close to equal, since execution rather than the original idea creates value, and why founders must formally purchase their shares through a stock purchase agreement rather than assuming a conversation is enough.

Vesting, including for solo founders (13:45)

Nathoo details the standard four-year vesting schedule with a one-year cliff, walks through a concrete example of shares repurchased when a founder leaves early, and explains why vesting matters even for a company with only one founder, both to align incentives and to set an example for future employees.

Raising money: priced vs. unpriced rounds and investor requests (18:30)

The lecture distinguishes priced rounds from unpriced rounds using safes or convertible notes with a valuation cap, and works through an example showing how an early investor's stake converts favorably at a lower effective price. It then walks through four common investor requests, board seats, advisor roles, pro rata rights, and information rights, and how each affects founders.

Business expenses and founder pay (28:21)

Nathoo and Levy explain the importance of separating company and personal spending, citing an example of a founder who misused investor money, and stress that founders must be paid a real wage (not only in stock) and that companies must properly handle payroll taxes.

Hiring, firing, and founder breakups (32:06)

The lecture covers the difference between employees and contractors for tax purposes, the requirement to use a payroll service and carry workers' compensation insurance, why unpaid founders create leverage in ugly founder breakups, and five best practices for firing an employee: act quickly, communicate directly, pay owed wages immediately, cut off system access, and repurchase any vested shares.

Key metrics and closing Q&A (47:25)

The talk closes by reminding founders to always know their cash position and burn rate, followed by audience questions on finding an accountant, budgeting for legal costs, and the added complexity of fundraising involving cryptocurrency.

Before you watch

• No specific earlier lecture is required, though earlier talks in the course on fundraising and hiring provide useful context for the paperwork discussed here.
• Basic familiarity with startup terms like valuation, seed round, and stock options is helpful but not required.

Check your understanding

1. Why do most startups incorporate in Delaware rather than another state?
2. What happens to a founder's unvested shares if they leave the company before the one-year cliff?
3. How does a valuation cap on a safe or convertible note reward an early investor?
4. Why do Nathoo and Levy recommend against giving disproportionate equity to the founder who originated the company idea?
5. What are the risks of not paying founders or employees a real wage from the start?