Summary of Key Points
This article focuses on the critical rules for raising funds while starting a business in the United States, advising entrepreneurs that to attract American investors, they cannot solely rely on product iteration but must also establish a corporate structure that complies with American venture capital (VC) regulations. It begins by examining the fundamental difference between a "business" and a "product," delving into essential issues such as the choice of legal entity type (with Delaware C-Corps being preferred), founder equity distribution (to avoid equal shares and to establish ownership mechanisms), and the differences in VC terms between China and the U.S. (common Chinese practices may lead to pitfalls in the U.S.).
Detailed Explanation
1. Investors Invest in "Companies," Not Just Products" – Build the Right Framework Before Financing
Many entrepreneurs believe that as long as their product is viable (as proven by a MVP), they can secure funding. However, American investors are interested in companies that are legally capable of receiving investment and transferring equity, not just the product itself.
- The Difference Between Products and Businesses: A product verifies whether an idea is profitable but lacks legal status (it cannot sign investment agreements or distribute equity); a business, on the other hand, is a legal entity that allows for legitimate financing and provides equity returns to investors.
- VC in the U.S. Is Like Meeting Specific Criteria: Everything from the company's structure to its regulations must meet market standards; missing any one aspect could deter investors. For example, you cannot simply apply Caribbean island practices (as they are not recognized by U.S. law). Exit strategies also vary: while IPOs are popular in China, ToB companies in the U.S. are more often acquired by larger corporations.
- What Does a Fundable Business Need? In addition to a good product, it requires five key elements: the right legal entity type and location, a reasonable equity and governance structure, an employee stock option plan, intellectual property protection, and a clear exit strategy along with financial forecasts.
2. For Financing-Oriented Ventures in the U.S., Choosing a Delaware C-Corp Is Almost Always the Right Choice
Choosing the right legal entity type is the first step when starting a company in the U.S. The two common options are LLCs and C-Corps, which differ significantly:
- LLCs Are Suitable for Businesses That Do Not Need Financing: For example, restaurants or car sales (like BMW's U.S. division). Their advantage is "pass-through taxation" – the company's profits are directly counted as the owners' personal income, reducing corporate tax burdens; however, they are less favored by investors due to complex tax reporting requirements, limited investment from certain LPs, lack of tax incentives (QSBS), and difficulties with equity incentives.
- C-Corps Are the Standard for VC: Especially for companies seeking financing, registering as a C-Corp in Delaware is recommended. Reasons include:
- Investors recognize this type of entity, and there are standardized documents (such as the NVCA template).
- Owners can benefit from QSBS (quasi-taxable sales bonus) if they hold shares for more than three years.
- Equity incentives are easier to implement, aligning with market practices.
- Why Delaware? State laws vary across the U.S., but Delaware has the most mature corporate law and a wealth of precedents, providing greater certainty in business operations (e.g., clear resolutions for shareholder disputes).
- Minor Disadvantages of C-Corps: Double taxation (company profits are taxed first, then dividends are taxed at the individual level). However, this is less of an issue for early-stage startups, as profits are typically reinvested in growth.
3. How to Allocate Founder Equity? Avoid Equal Shares and Use a Contribution-Matched Mechanism
There is no fixed formula for equity distribution, but there is a consensus in the U.S. market:
- Avoid a 50:50 Split: This can lead to decision-making paralysis and is unappealing to investors, indicating that the team is not prepared to handle disagreements.
- Allocate Equity Based on Value Contribution:
- Distinguish between "founders" and "early employees"; those seeking stable salaries should receive cash or stock options instead of equity. True founders are willing to take risks and seek long-term returns.
- Evaluate five key aspects: vision and leadership, technical/product capabilities, execution, contribution to financing (e.g., bringing in capital), and industry resources/ customer acquisition skills (GTM).
- Initial Equity Ratio Should Not Be Less Than 10%: Subsequent financings will dilute equity; starting with only 8% may result in just 3-4% after multiple rounds, which may not motivate founders to stay.
- Establish a Vesting Mechanism: Share ownership is granted over time based on performance (e.g., 25% after one year, with the remainder distributed monthly).
- Proactive Vesting Is Better Than Reactive: Waiting for investors to propose a vesting period (e.g., eight years) may result in a longer requirement that the company cannot afford.
4. Significant Differences in VC Terms Between China and the U.S.: Some Common Chinese Practices Do Not Work Here
Some standard terms used by Chinese investors are rare in the U.S. and can affect subsequent financing:
- Personal Liability of Founders: Chinese VCs often require founders to provide personal guarantees, but this is not common in the U.S.; investors focus more on the company's value.
- Buyback Rights: Chinese investors frequently request buybacks at maturity, while this is less common in the U.S.
- Protective Clauses: Chinese investors have broader lists of veto rights (e.g., managing daily operations), whereas in the U.S., they only affect major decisions (such as financing and acquisitions).
- Liquidation Preferences: China requires an annualized 8% return, while the U.S. typically only demands a return of the principal.
- Equity Incentives via SPVs: Limited partnerships are commonly used for equity incentives in China, but they are rarely used in the U.S., as they can complicate subsequent financings.
- Stringent Securities Law Regulation: The company is subject to securities laws from the day it issues shares. Activities like participating in demo days or sharing financing information on social media can impact the legal feasibility of financing.
This article essentially serves as a guide for entrepreneurs aiming to raise funds in the U.S., emphasizing that they must follow American rules, from the company's structure to its contractual terms. The core message is: Build a compliant corporate framework first, and then focus on your product and fundraising strategies.