Running a PAYE Scheme with Gnucash

If you're a startup then you're unlikely to want to pay for a commercial accounting package. One option is to use the free Gnucash application, which is an excellent open source, double-entry accounting package. However, trying to run a UK Pay As You Earn (PAYE) scheme for your employees using Gnucash was not, at least for me (!), totally obvious. Here's how I ended up solving this particular problem.

Background

For those not familiar with UK PAYE schemes, the basic idea is that the employer deducts income tax and National Insurance Contributions (NICs, similar to Social Security in other countries) "at source". The result is that an employee's gross salary has these deductions made to it, and they are paid the net salary, thus meaning that most employees do not need to make tax declarations at the end of the financial year. In addition to NICs made by employees, employers also contribute NICs (at a rate of 11% of the gross salary).

Accounts Needed

Gnucash works on the principle that expenses, liabilities, assets and income are all split into different accounts. For keeping track of a PAYE scheme, here are the accounts that I use:

• Expenses:Payroll Expenses (you probably already have one of these as it's a default Gnucash account). This will keep a running total of only the net salary that you pay employees, i.e. it excludes the income tax that you as an employer deduct from the employee's gross salary, the employee National Insurance Contributions (NICs) that you also deduct, and the employer NICs (extra, on top of gross salary).
• Expenses:Income Tax, Expenses:Employees' NICs, Expenses:Employer's NICs. These enable you to keep track of how much each of these have cost the company.
• Liabilities:Income Tax Payable, Liabilities:Employees' NICs Payable, Employer's NICs Payable. These keep a running total of how much of each type of tax the company currently owes HMRC.

Recording an Employee's Hours

Depending on how your scheme is set up, you may pay your employees by the hour, or per week or month. I (mis)use Gnucash's concept of an "Expense Voucher" to record these. When you wish to record the employee's hours, simply create a new voucher ("Business", "Employee", "New Expense Voucher"). Make four entries in the voucher, one each for the income tax, two types of NICs, and of course the net salary. The expense accounts for each of these are those detailed above (i.e. Expenses:Payroll Expenses, Expenses:Income Tax, etc.). The liability account for this will be the default Liabilities:Accounts Payable, as none of these amounts have actually been paid yet. Post the voucher to the accounts ledger in the normal way, with a due date of the end of the month (or whenever you pay your employees).

(Note: in order to calculate the amount of tax and NICs due, you'll either need to calculate it manually, or use the tools on HMRC's Employer CD-ROM.)

Paying an Employee

When the end of the month comes (or whatever period you use), the expenses vouchers will pop up in the bills due dialogue. With "normal" bills, you would "Process Payment", and pay the full amount. Under this scheme, it's a little more complicated: you need to process each voucher four times (sorry!).

The first time you pay the employee their net salary, so enter that number into the amount field of the "Process Payment" dialogue box. The account that the money is transferred from is likely to be your Current Assets:Checking Account, as you'll be giving them actual money on their payday.

The second time you process payment you'll "pay" the income tax. The transfer account should now be your Liabilities:Income Tax Payable account, as you're simply transferring a liability from your general "unpaid bills" account to the specific one for income tax that you owe to HMRC (and pay on a different timescale to your employees: potentially you may only pay HMRC quarterly if you have a small wage bill).

The third and fourth times are used to similarly transfer liability for the employees' and employer's NICs to their respective liability accounts.

You should now have ended up with four entries in your Liabilities:Accounts Payable account, which reduce the balance by the total of the original expense voucher that you used to record the employee's hours.

Paying HMRC

Each month or quarter, you'll need to pay HMRC the NICs and income tax that you have deducted. All this involves is looking at the balance of each of Liabilities:Income Tax Payable, Liabilities:Employer's NICs Payable, and Liabilities:Employees' NICs Payable, and making a transfer from your Current Assets:Checking Account to each of them to zero the balances. Evidently these transfers from your checking account should in reality be going to HMRC.

Note: one thing that caught me out recently was being too efficient, and paying HMRC too early (!). One company I'm involved with makes quarterly returns, i.e. we don't pay NICs/income tax every month. I transferred the amount for the quarter ended July 5th at the end of June. Later I received letters about how they hadn't received the July payment... Turns out that if you pay before the date the quarter ends, they assume that the payment must be for the preivous month... You have been warned!

Conclusion

It's not an ideal system (processing the same voucher four times is a pain!), but it does mean that every number ends up in the correct account. If anyone has any good suggestions on how to make this process better, please comment!

(Note: Having been silent over the summer, mainly down to starting a new job, I'll now hopefully return to a more productive autumn as regards blogging!)

What Tasks Need to be Completed When Starting a Limited Company?

Having helped start two companies, another that I'm involved in is soon to incorporate. Here, I'll list the various steps you need to go through when setting up a new private limited company, in the United Kingdom.

Register with Companies House

Companies House has the details of all companies trading in the UK. This includes details of directors and shareholders, as well as financial information (accounts). Incorporation involves filing the relevant form, together with a small fee, with the Registrar of Companies. The snag is that the form needs to have the signature of a witness that is deemed "official". This boils down to needing a lawyer to watch you put pen to paper. Instead of the hassle and expense of doing this, you can either buy a ready-made company from one of the many firms offering them, or use an electronic incorporation service. In the latter, the service acts as the witness, and files your incorporation forms for you. The fee over and above Companies House's own can be as little as £5, and it's worth shopping around. The list of companies offering electronic incorporation services is on Companies House's web site. Note that all such firms will try to sell you all sorts of other services (e.g. doing your accounts for you, running your web site). You only need them to submit your Form 10 and Form 12 to Companies House, and send you back electronic versions of your company documents.

Companies House has a vast amount of guidance on the intricacies of incorporating, and running, a company. Take the time to read it, particularly the Guidance on Company Formation.

Register for Electronic Filing

Whenever you need to change the address of any director or the company secretary, or file the annual return, Companies House allows you to do this electronically using their WebFiling service. You can also opt for their PROOF scheme, in order that they will only accept documents electronically rather than also by post. This has the advantage that it is much faster, and also more secure, as it prevents random people sending in false changes of address for your company. Registration for WebFiling necessitates asking Companies House to send you an activation code through the post, whilst PROOF also requires you to send them a paper form.

Register as an Employer

Company directors are required to fill in an Employment page in their self-assessment tax returns for each company they are director of. HMRC tell me that this applies even if the director did not actually earn anything, which implies that as soon as a company incorporates, it has employees in the form of its directors. (Note that this conflicts with the idea expressed in the "When You Need to Register" (as an employer) section of HMRC's guidance, which implies that if employees are not paid very much, registration is not necessary).

In order to be an employer, the company must register as such with HMRC, and can use their Send New Employer Details by E-mail tool (provided that the company has fewer than 9 directors, and does not operate a "simplified" PAYE scheme with more than 10 employees. If so, register by telephone).

Within a few days, your accounts office reference and PAYE (Pay As You Earn) reference numbers will come by post. These are needed when filling in PAYE forms, and by your directors for their tax returns.

Register for PAYE Online Services

Having obtained your PAYE reference, you can now register for using HMRC's PAYE online tools. These make life easy as regards keeping track of employee data, and submitting forms (e.g. when you take someone on, or submitting P14s at the end of the tax year).

Registration for online PAYE services requires you to create a Government Gateway ID and password, which is sent to you in the post, along with an activation code. You'll then be able to tell HMRC that you're employing your directors.

Inform HMRC that PAY/NICs Contributions will be Nil

If you will not be paying your directors anything (in cash or any other benefit), you are unlikely to owe HMRC income tax or Class I NICs (National Insurance Contributions). Normally, such payments to HMRC are made monthly, or quarterly for small businesses. However, you can inform HMRC that your returns will be "nil returns" for the foreseeable future, which will remove the requirement on you to keep sending these in. For the telephone number for this, see the No PAYE/NICs Payment Due page. You can also use the form on that page to send in nil returns for any months/quarters where you do not owe any PAYE/NICs, but have not notified HMRC that you will be making nil returns for an extended period of time.

Take Out Employers' Liability Insurance

If you are intending to pay your employees anything at all, you are almost certain to be legally required to take out employers' liability insurance. Take a look at my post Do You Need Employers' Liability Insurance? for more information on this.

Register for Corporation Tax Online

Soon after your first year of trading you'll receive a Corporation Tax return in the post from HMRC. You can also file this online (which makes life easy, as the paper form covers many cases which are unlikely to apply to you), but have to register to do so. You can only do this when you receive your UTR (Universal Tax Reference) number, and hence probably won't be able to do so at the time you register for PAYE online. Oh well... See Corporation Tax online registration (fortunately, you can use the same Government Gateway ID as for PAYE online).

Conclusions

If you've managed all of the above, congratulations! All you now have to do is survive your first annual return from Companies House (where you detail who the shareholders are), and file your accounts with them (which also need to be filed with HMRC).

If all of this fills you with fear, an accountant will be able to help, but of course they'll charge you money. If you're a start-up in Cambridge who needs someone on board to help navigate through the waters of legal and financial bureaucracy, I'm job hunting!

Do leave any questions/comments and I'll try to address them in a future post.

Do You Need Employers' Liability Insurance?

I'm involved with three companies: N-Sim, a software consultancy, Accuvex, a holding company, and Verieda, which works on EDA tools. When each of them has been started, the same question has gone through my head: "do we need to take out employers' liability insurance?".

Employers' liability insurance, or ELI for short, is normally required by law in order to protect your employees. For example, if an employee on a building site falls from some scaffolding, (hopefully!) the company's ELI will pay out. In the United Kingdom, the minimum cover is £5 million, and most policies offer cover of £10 million.

For many companies, the question of "do I employ anyone?" has an obvious answer. Construction workers are a case in point. However, when it comes to software companies, it might not be such an easy question. "Surely", the argument goes, "I don't need ELI if I don't employ anyone, if all my work is done by contractors?".

Exemptions from ELI

The UK Health & Safety Executive have a guide to ELI for employers, which describes what exemptions there are. In particular the following are exempt:

• Most public organisations (government departments, police...), and health bodies.
• Family businesses where all employees are closely related to the owner (but not when the business is a limited company).
• Companies which only employ their owner, where that owner owns 50% or more of the issued share capital.

I'll assume that we're dealing with a private limited company, probably writing software, and hence that the first two exemptions aren't relevant. The 2004 amendment to the 1969 Employers' Liability (Compulsory Insurance) Act allows only for a company with a single employee (who fulfills the 50% criterion above) to be exempt. Hence, two directors who split the equity equally and are employees are not exempt.

That's fine, but what about companies with unequal shareholdings, or more than two directors, or with contractors? Who counts as an employee?

Who's an Employee?

For income tax purposes, directors of limited companies are treated as employees, and hence fill in the "Employment" pages of their self-assessment tax return. In most cases, this is reasonable, since the directors are likely to be deriving benefit (salary or dividends) from their work, and moreover are essential (difficult to replace) in the company's normal function. They cannot subcontract their responsibilities, nor (generally) do they provide their own tools for doing the job. All of these aspects are some of the tests of whether someone is employed by the company, or a self-employed contractor.

On the face of it, then, companies that employ more than one director need ELI.

However, the HSE's guide to ELI for employers also says that "you may not need [ELI] for people who work for you, where they do not work exclusively for you". Clearly, this is relevant when a contractor performs some work for the company, but also carries out similar work for other entities. It is important to note that the HSE's definition of who is an employee is distinct from HMRC's (Revenue & Customs) definition: someone's tax arrangements may mean they are defined as self-employed, but from an ELI perspective, they may be an employee. I'm going to assume that this provision does not apply to part-time employees of your business, who have another job. It's unclear, though.

Of course, if you're a start-up company, and you don't pay your directors anything, then they don't count as employees for ELI (see HSE's guide to ELI for employers again), but the company can still be held liable in case of a claim for compensation, so taking out ELI might still be wise. Hence, one exemption might be to have a director, who owns a majority shareholding, being an employee, whilst having another person helping you out, who is unpaid. Bad luck for the unpaid person...

So Who Does Need Employers' Liability Insurance?

If you're a one-person band (with a majority shareholding), and only use contractors (who satisfy HSE's tests for not being employees, rather than just having self-assessment status for tax purposes), you're likely to be exempt. In any other case, you're not.

Which brings us to an interesting conclusion: if two friends start-up a limited company that sells shareware software, both of them being directors with 50% holdings, and carrying out part-time work for the company for which they are paid, say, £10 a month (it's a small company!), it seems that they need ELI. This is despite the fact that they are both directors, working from home, earning tiny amounts, and would be stupid to sue themselves. Perhaps this is one reason that such small companies shouldn't bother incorporating.

Having said that, note that if you have a limited company that is not paying its directors (e.g. because it's just starting up, or is dormant), it appears that ELI is not necessary.

(Note though, that if you're a director, when you want to fill in your tax return, you'll need an "employer's PAYE reference". This can only obtain by registering the company as an employer with HMRC. And then not paying yourself anything to avoid needing ELI. Oh well...)

But ELI Costs Too Much!

It's definitely worth shopping around: different insurers quoted us wildly disparate premiums. Policies tend to be based on how large the company's wage bill is, hence the premium doesn't have to be unmanageable. Different companies will have different minima for such total wage bills (one reason for shopping around). At present, N-Sim uses Zurich Insurance, who meet our needs well, though they do include (for free) a public liability insurance that does not cover our main line of business which is selling software consulting services. Nevermind...

Update (21/04/2009): Just found the statistic that around 210,000 SMEs in the UK do not have ELI. Not really a surprise, given the costs and how one could easily think "we're friends, we won't sue each other"...

How Charity Funding Could be More Venture-like

I'm currently standing for election to the General Council (a.k.a. Executive Board) of Crosslinks, a Christian missionary society. One of the reasons for this is that I believe that charities have a lot to learn from the way businesses are run. Something that I've recently been thinking about is how funding for charitable projects could be more like funding for start-ups.

V-Cs vs Charities Today

On the face of it, V-Cs and charities are hugely different. Charities receive donations, and use those funds to work towards some worthwhile purpose, but one that generally does not make large profits. Start-ups receive seed or venture capital funding in order that (hopefully!) the company will grow, make large profits, and hence deliver a good ROI.

However, today, giving to charity is far more project-based than organisational. What I mean by this is that we now prefer to support "tsunami relief in Asia", rather than (as previously) Oxfam or Christian Aid. We feel more involved in the work, and have a clearer idea of where our money is going. Transparency is becoming more important. Goal setting and satisfaction are key to convincing donors that our project is worthy of their money.

It seems to me that charity donors are becoming increasingly similar to company shareholders. Of course, the return on our investment comes not in the form of monetary dividends or increased share valuations, but rather in the successes achieved by the projects we support. The demand for transparency, and the availability of information (everything from easily accessible charity accounts, to Google Earth views of project areas, to YouTube videos issued by project members) means that donors can be far more involved in projects. This can only be a good thing.

Today, many volunteers for charities are asked to raise their own support, i.e. convince their contacts to pledge the requisite amount of donations to pay for the overheads of having that volunteer on the project, and perhaps pay them a stipend. Charities become organisations that have a particular focus (perhaps a geographical area, such as East Africa, or a well-defined purpose, such as clearing landmines), and have contacts and expertise in their focus-area. They can help volunteers (who have their own funding) to best achieve their projects' goals.

Proposal: Seed Fund for Charities

Here's my proposal: create a fund, similar to a venture fund, that is financed by donors. The fund would have a well-defined focus and a well-qualified board, in order to evaluate potential project investments. People with good project ideas come to the fund, with the equivalent of business plans, showing what money is needed to start the project off, what goals the project has, and how measurements will show whether those goals have been satisfied. The fund invests over, say, a period of five years. During this period, it provides advice, (or uses its network of contacts to provide this), and in addition provides the seed funding to employ a professional fund raiser to make the project self-sustaining. After the five years, the project is evaluated, in the same way a start-up is, in order to ascertain whether it can be "sold on" (or perhaps, "spun out" is better, since no profit is gained) to be self-sufficient, whether it needs a little more funding/time to become so, or whether it should be wound up.

This is different from social enterprises in that there is no monetary return on investment. Ultimately, it is still about charitable giving. The key is to better enable projects to hit the ground running, and have a significant impact sooner, rather than the uncertainty of beginning a project with "just enough" money. It also means that the usage of donors' money is overseen by an independent, experienced board, rather than by (potentially) inexperienced volunteers.

Existing charitable organisations still have a significant role in this paradigm. Today, they provide expertise and contacts to volunteers, yet have no control (really) over what self-funded volunteers do. In my model, the charity acts as a service provider, for example, helping with the administration tasks of a project. Remember that after the first five years, the fund will bow out, and it will be "normal" donors who fund the project! Donor relations are hugely important. Expertise in the particular area the project is intended for is also crucial.

How is this fund different from grant-making bodies? In part, it is not: grants may well imply supervision, similar to that the fund would provide. However, my proposal is that the fund is financed by donors, like you and me, rather than government or other large entities. Of course, there is no reason that corporates could not get involved, showing how their charitable giving is being well-invested.

But isn't this fund like one of today's charities, which takes donations, and then uses them however it sees best? Of course, that is the aim. They key here is that the fund provides seed finance. It allows projects to get started, even if they have significant up-front capital expenditure. It then guides them to maturity, before letting them loose, either on their own, or under the umbrella of another charity. Today's charities aren't built around that model, though some, like Cancer Research UK, are becoming more V-C-like.

It's also important that the donors to the fund are kept very up-to-date about how their investment is performing. In my view, many charities fail here. The Internet has provided huge opportunities for cheap communication between donors and project volunteers. Let's use it. If a charity today doesn't have a fan page on Facebook, at least one blog on its activities, volunteer updates on Twitter, YouTube videos showing how projects goals are being met, and a regular e-mail to its supporters, it's falling behind the times. This is where this fund differs from a V-C, in that the only way ROI can be measured is how people perceive their money is being used. There is no single figure that can be labelled as the fund's "return". However, just because the return is not monetary does not provide an excuse for less shareholder involvement: it implies the need for more!

Why is this paradigm important?

• It allows donors to contribute to promising projects that are just starting out.
• It separates the tasks of financial investment from the on-the-ground activities of the project (why should volunteers helping with refugee work be expected to be good finance directors?).
• It provides clear structures and requirements on transparency for projects that are funded.
• It encourages projects to become self-sufficient, or else have clear timescales by which they are wound down.
• It frees traditional charities from the dichotomy of funding their back-office functions versus charitable activities, by allowing them to be specialised service organisations that are contracted by projects carrying out charitable activities.

Conclusions

• Existing charities need to become more service-oriented, being contracted for their expertise by projects (possibly funded by charitable seed funds).
• Volunteers can come to such funds to gain start-up capital, contacts and advice, and have their project proposals vetted.
• Communication between project volunteers and donors is of paramount importance in an age where greater transparency is the order of the day.

This idea is very much a work in progress. Please comment and tell me where I'm wrong!

Update (19/04/2009): Serena Fassó pointed me to Social Venture Partners Calgary, who do roughly what I've described! Note that this type of scheme differs from Social Venture Capital, which normally involves capital that is ethically invested, but still has the objective of achieving financial return.

Steve Johnson on Product Management

More notes from another Business of Software 2008 lecture by Steve Johnson from Pragmatic Marketing. He talks about what product managers' role is, what they actually end up doing, and what they need to do, in order to be meaningful representatives of the actual product's users.

• Companies tend to start off as technology-driven, then become sales-driven (each new sale requires custom development), then become marketing-driven (lots of money spent on their brand image).
• Then they cut costs, and go full circle to technology-driven, and repeat the cycle. Good product management can help to break this cycle.
• Illustration of how wills are only executed: you are already dead when the will gets to court. So the document needs to be long enough to deal with all possible arguments.
• Application specifications have the advantage that the specifier is normally still alive when the development teams come to implement them!
• But we keep writing specification documents (product requirements, marketing requirements, functional specifications...) in order to cover all managers' worries/requests.
• The right answer is not to create more artefacts. Tightening your grip will mean more slips through your fingers. Instead it's to have someone who really understands what's needed, and can back up their assertions with evidence.
• Many companies are like Star Trek (original series): Spock (development) logical, trying to be human. Bones (marketing) upset about what he hasn't got, or what he's being asked to work with. Kirk (sales) always committing the ship to more than it can do. Scotty (product manager/sales engineer) lies to Kirk at all times, then says "OK, let's go!".
• Agile development crowd wants to improve these development/specification processes by having a customer representative on hand to try out each iteration on.
• Problem: most of us don't program for individuals. We program for multiple customers!
• Agile/Scrum methods seem to make us more introspective. We spend so long in development team meetings that the product manager does not go out and talk to the customers!
• Sales don't tend to understand why some of their development requests are not possible. An interesting idea is to turn this round and ask similarly unrealistic questions to sales. Example: "Why can't you give me a well-defined feature set by a guaranteed date?" is replied to with "Can you tell me what hour of the day and the exact amount that you're going to close this contract for?"
• In many cases, the only people who talk to customers are technical support. But are they talking to all of our users? (Hopefully not!) They're only talking to the people with problems, and not even all of them. What comes out of this? "Remember the 'L' in (L)user is silent". "Losers" are those who you have to teach basic computing to. "Power Losers" are those who are trying to use your product in ways that you never intended. But you can't just try to market to "smarter" users!
• Biggest contribution that a product manager can make is to be representative of users. That means the PM has to leave the building, and talk with users, and potential users!
• Causing customers to switch is one target, but selling to potential customers is hugely important.
• Three groups: current customers, evaluators (people currently shopping: only sales talk to them. If they don't buy, then product management analyses why), and the untapped potential market. The last group is very important.
• Customers tell us what new features they want, but potentials tell us what would convince them to buy. Get evidence for what features are really asked for by customers. That helps choose which of the many ideas that come out of our company are to be implemented.
• Development and Sales have different views of product managers should do. Sales tend to want people who can demo/explain the product. This is probably best done by sales engineers. (See Steve's post on sales people as order takers.)
• Work out what areas of the business that are thought of as product management are not actually officially assigned to someone at your company: they will be happening, but are they happening well, or "just being done"?
• Jargon: Inbound marketing is understanding what customers want the development team to do (product management). Outbound marketing is about actually selling the product (product marketing manager).
• The product management triad: executive direction, marketing, and technical management. All require different skills. May end up splitting into three separate roles.
• Sales people tend to think one deal at a time, which is as needed. But when sales comes back with a new idea, put it in the list of possible new features, but wait and see how many people actually want it, rather than just the one deal that that salesperson is currently progressing.

To me, it's interesting how broad the role of product management can be. It's also a salutory reminder that when two companies recruit for a position with the same name, it might well be for totally different roles...

How to Value an Investor's Stake

I'm currently looking at a draft version of an entrepreneurship course written by, among others, people from Cambridge's Judge Institute, and hosted by Epigeum. Something that I found particularly helpful was how to decide what percentage of a company to sell to an investor for the particular amount of money the company needs. I've summarised it here.

The Value of a Stake

If the company is seeking capital worth c, then the issue is to calculate s, the percentage of the equity that should go to the investor providing that capital.

Firstly, assuming this is venture capital, the investor will look to exit probably within five years. Call this number of years y. Let r be the amortised annual rate of return that they desire, say 45%.

Hence, we can say that when the business is sold after those y years, the investor's stake should be worth w = c(1 + r)^y, as this provides the desired rate of return.

Therefore, the stake is simply the fraction that w is of the selling price (market value), p, of the business. Of course, how does one estimate p?

The answer lies in using the Price/Earnings (PE) ratio for a similar, established, company, which details their worth as compared to their sales. Assuming that we can predict the likely earnings of the company in y years' time, then we can multiply this by the PE ratio in order to obtain p.

Investors may well discount the PE ratio, either because they do not believe it to be realistic, or because of the perceived risk, or because the expected revenue is uncertain.

As an example, assume a £1 million investment is needed, that r = 45%, and y = 5. This means that w = £6.4 million. If projected sales in year 5 are £1 million, with a PE ratio of 15, p = £15 million. Thus, the initial stake would be 6.4/15 or 43%.

Which is food for thought. It does very clearly show how VC investors "need" to take very large equity stakes in order to make the desired rates of return. Hardly surprising, but it's nice to at least vaguely understand the mathematics behind it all.

Understanding Dilution

This brings us neatly on to what actually happens when you sell the stake.

Let's say that an investor offers you the £1 million for 43% of the equity. That means that the investor is valuing the entire company (prior to the investment) at £2.33 million, and in particular, valuing the 57% stake you will be left with at £1.33 million.

Suppose that prior to the investment the total number of issued shares (all owned by the founders) is 10,000. This means that the price placed on those shares is £133/share.

Why is it not the case that the price is calculated based on £1 million for 43% of 10,000 (giving £233/share), leaving the founders' 57% stake being worth £1.33 million?

Whilst the ownership percentages would be correct, this is not done because dilution takes place. In other words, the company issues new shares to the investor, rather than re-assigning existing shares.

In the above example, given a price of £133/share, the investor must be given £1 million/£133 = 7,518 shares. Post-investment, the company will be worth a total of £2.33 million, divided into 17,518 shares. The founders will hold their 10,000 shares (as before), but these are now only 57% of the company, whilst the investor will hold 43% (17,518 shares), worth a total of £2.33 million * 0.43 = £1 million.

There you have it: the end result is as proposed, i.e. the investor bought the agreed percentage for the agreed price. The only somewhat potentially confusing part is how this is brought about by dilution, rather than share re-distribution.

Do You Really Need a Patent?

Back in June 2008 I attended a seminar on intellectual property rights (IPR). A lot of the hype around entrepreneurship seems to centre around the idea that one must have patents to protect a company's IPR, otherwise the sky will fall, or at least, the company won't be worth anything if and when you want to sell it. Here are my notes on why that isn't necessarily the case, what you can do (other than patenting) to protect your IPR, and what role patents do have to play.

Patents protect functional designs by granting a monopoly to the holder, ensuring that no one is permitted to produce a product that carries out the same function in the same manner, regardless of whether that invention was independently conceived (see Out-law's article "Patents: the basics"). In principle, this means that the holder has a 20 year head-start on their competitors. The downsides are that when a patent is granted, the details of the invention are publicly disclosed, and that registration and maintenance of patents costs huge amounts of money, particularly if one wishes to hold the patent in multiple countries. Asking a friendly lawyer to waive their fees on the promise of future profits may help with drafting the document, but not with the Patent Office fees.

Do you need a patent?

Firstly, it's important to realise that there are rights for which there is no need to register. These include:

• Copyright: prevents exact copies of your work (literary, film, software) being made. Note that this does not prevent against quite similar designs, provided that these were the product of independent creativity. In the UK, copyright is automatic, i.e. there is no need to assert your claim via a legal message (though many people choose to, for clarity). See Out-law's article "Copyright law: the basics".


• Design Right: unregistered design rights cover aesthetics qualities, such as the form, colour, look and feel, or texture of a product. For software, look and feel is hard to protect with copyright (though logos can be), whereas it can come under design rights. Registered design rights (fee required) allow the holder to enforce a monopoly, i.e. even an independently created identical design would be an infringement. In contrast, unregistered design right only prevents direct copying. See Out-law's article "How design rights can add value to a business".


• Semiconductor topography right: design rights protect aesthetics, whereas semiconductor rights protect the layout of integrated circuits that are used within a product. The main reason for this is that the different layers of such circuits can be easily photographed, and then copied, but the investment required in initial design may be enormous. See ESA's article "About semiconductor products", and Mewburn Ellis' article "UK & EU Unregistered Design Rights".


• Database right: a database is essentially a systematically ordered collection. The items within the collection may or may not be subject to other protection, but the effort/costs in amassing and organising the collection is what is protected by database rights. It is important to note that such costs are solely those of collecting and verifying the data, rather than those of creating the data. See Out-law's article "Database rights: the basics".


• Trademarks: the goodwill associated with any design that can be represented graphically, such as a name or a shape can be protected against a competitor "passing off". This takes place if they use the trademark in such a way as to take advantage of the goodwill associated with the mark. Registering a trademark does cost a fee, but additionally ensures that the mark is protected more widely, in areas you may not yet be trading in. Not registering may mean that another party does register it, and later prevents you from using it. See Out-law's article "Trade Marks: the basics".

The key point is that all of these are IP rights, but they don't cost anything (at least, the unregistered versions). It might well be that you're actually better off registering (or not) one of these rights instead of trying for a patent. Note that all rights are time-limited.

Secondly, is the patent registration actually worth it? Patent ideas can (hopefully!) be commercialised, but they must generate enough cash to defend the patent! If the value of the invention (or subsequent inventions that might depend on it) isn't high enough, there's little point in patenting.

Thirdly, 18 months after filing, the idea will be revealed. Do you actually want to reveal anything, rather than relying on keeping the mechanisms of your invention secret? Competitors can catch up fast after your public disclosure! Even if you decide to patent, when is the right time to reveal? Waiting longer may mean your competitors develop a similar technology and file a patent, but may also mean that you can develop the details further, and hence file a broader and more detailed patent, which may be more defensible. Dragging out the filing process as long as possible will mean you have the protection of a patent application, and yet are not liable for maintenance costs.

General Patent Advice

As regards working with another company, the received wisdom is to never give another company joint ownership of your patent. If this happens, questions of how revenue is to be shared, or who dictates the territories that the patent is registered in, arise. Licensing to the partner company is by far the best way, particularly if your partner subsequently wishes to sell their portion of the patent (rather than having a license) to one of your competitors!

Note that a single patent may not be enough. Again, the advice is that defence in depth is a definite advantage, which guards against a "bad" court judge ruling in your competitor's favour. Of course, the more patents, the higher the costs...

Prior art constitutes any expression of the proposed invention that is already publicly known about. Hence, if you are the first to invent, prior art will, by definition not exist. The concept of "first to invent" is particularly significant in the United States. There, one possibility is to use lawyers to store date-stamped ideas in their safe, thus acting as witnesses to the statement of when the invention was created, whilst not releasing the idea publicly. Several ideas stored in such a way can later be included in a single patent, thus reducing costs.

When drafting a patent application, you could of course attempt it yourself. However, if you seriously intend it to be useful for later enforcement, it is far better to bite the bullet and contract a good lawyer. Failure to invest at the beginning may well mean a far greater loss later on.

Finally, it's worth asking why patents are regarded as so important. One reason is that investors are keen to ensure that their stakes will appreciate in value. This will not happen if the company's core product is able to be copied by a competitor. Because patents grant a monopoly, provided that the invention is in demand, the patent holder has a guaranteed revenue stream.
Hence, when, for example, a venture capital firm invests, their due diligence procedures involve checking that the source of the company's core business is patented. One corollary of this for startups is to ensure that all employees and contractors are contractually obliged to cede any IPR they generate to their employer, thus clearly stating the ownership.

Views from VCs: Notes from The Investors' Forum

Yesterday evening I attended The Investors' Forum, an event jointly organised by CUE and CUTEC in Cambridge, aiming to show that there is still investment available for start-ups. On the panel at the event were Reshma Sohoni (SeedCamp), and Laurence John (Amadeus Seed Fund), who talked about (pre-angel) seed funding; Kerry Baldwin (IQ Capital) for injections of around £1.5 million; and Simon Cook (DFJ Esprit) and Sitar Teli (Doughty Hanson Technology Ventures), for investments of £10 million or more. Alex van Someren (nCipher) moderated and gave the entrepreneur's viewpoint. Here's my notes on what they said:

• The economic downturn has affected some funding decisions. Seed funds are asking companies to try to do more with less investment, and to have working demonstrations in less time. Larger funds have been used to their companies not being able to obtain bank loans, hence there has always been a sort of "credit crunch" in that area, thus no effect. However, Sitar Teli pointed out that some businesses (such as semiconductor manufacturing) would need to take on debt at some point, and at present that type of company would not be a good investment.
• Software start-ups were more likely to receive seed funding than hardware start-ups, due to their need for smaller amounts of money. However, hardware is still an option (Laurence John).
• Proposals seeking VC investment need to show both a strong business case, but also a robust customer base. Previously investors would not have checked as rigorously as now how strong the market is (Kerry Baldwin).
• Investors did not believe that they were using the economic downturn to drive down the price they offered entrepreneurs for equity stakes.
• When coming with a proposal, it was emphasised that the amount being asked for should be planned to result in a real step change in the company. Similarly, a plan of what funding will be needed at which points in the business, and what the end dilution and valuation will be, is hugely important in order to ascertain whether an investor will even consider the company. If the end valuation means that the investment does not gain very much value, evidently investors will not be interested.
• Getting to know VCs before asking them for money was recommended. This allows them to be more confident in you at the point where you ask for investment.
• Select which VC to court carefully. There is little point going to one that invests £10 million minimum if the company only needs £250k.
• Try to court multiple investors, in order to allow the market to set a fair price for a stake in the business. Otherwise one investor can effectively set as low a price as they wish.
• The relative importance of teams versus ideas was debated. For seed funding, where ideas are at a malleable stage, the quality of the team was regarded as most important (Reshma Sohoni). For larger investments it was less obvious which was most significant.
• Experience was regarded as hugely important in obtaining large investments at the start (unsurprisingly). First-time entrepreneurs should normally start with seed funding. The exception was if there was significant, patentable IPR behind the business idea.
• In any presentation, get to the point, and explain how much investment is needed, and what it will be used for.

All sounded sensible, though valuable as it goes to show that some investor attitudes have changed, whilst others have not.

Lessons from Hermann Hauser

Another interesting Enterprise Tuesday lecture by serial entrepreneur and angel investor Hermann Hauser (Amadeus Capital Partners). He talks about the mistakes he has learnt from in five of the 62 companies that he has been involved with: Acorn, ATML, Harlequin, ART, and Polight. Here are my notes and thoughts:

• Acorn spent its first five years not being able to produce enough computers to meet the demand. It therefore signed long-term agreements with manufacturers, and eventually met demand. Unfortunately, at this point the market crashed. Inventory piled up, and the company had to be rescued by Olivetti. Corollary: understand the variations in your market, and plan inventory sizes appropriately.


• ATML's initial product was (probably) the best 25 Mbit/s ATM switch on the market. This did not sell, as 100 Mbit/s switched ethernet soon arrived on the scene. Larry Ellison (of Oracle fame), invested in the company, and hence kept it afloat. However, the company began to make significant sales of its ATM to IP "conversion" chip to manufacturers of DSL modems. The business model was then changed, resulting in real growth. A merger with American company Globespan was proposed, but this turned out to be a bad move, as their management team was not as strong as ATML's (by this time Virata). Corollaries: product strategy needs to be correct (and malleable); don't assume that as a British company you need to be bought by an American company to succeed.


• Harlequin's aim was to build the world's greatest AI company, by producing a LISP interpreter. But this wouldn't be profitable, as it would be a small market. In order to obtain revenue, the company produced PostScript technology for printers. The founder refused to raise cash through selling equity, but wanted to raise debt. Natwest gave him a £5 million loan. That increased to £10 million. The difference between banks and VCs is that banks can call in the loan. Harlequin was sold for £1. Corollary: in a fast growing, high-tech company, you need equity, not loan, finance.


• ART (Advanced Rendering Technology) made a break-through in hardware rendering technology. Genereated photorealistic images for car companies. But there were only so many car adverts that needed making! Corollary: market size matters!


• Polight produced holographic storage technology. Unfortunately, a very gifted physicist on the team showed that it was in fact impossible to produce the technology that they were working towards. Corollary: sometimes the technology itself may be at fault.


• Time estimation: whatever you estimate, multiply by Pi to get a realistic estimate. Similarly, market size estimates tend to be very overstated.


• People-related issues are common: people fall out with each other surprisingly easily.


• Finally, keep making mistakes, but make new mistakes.

Personally, I think that much of the above is obvious in hindsight. In other words, I'm sure that ART were aware that they needed a big enough market in order to generate sales growth long-term, or that Acorn would not have signed manufacturing contracts if it had known that demand was going to fall. Perhaps the most interesting conclusions to be drawn centre around how ATML was nimble enough to change their strategy (i.e. that they were willing to sell that one chip that was a tiny part of their much more complex core product), and that they would probably have done better not to merge with Globespan.

So how to avoid the "obvious" mistakes when starting out? Clearly it's not easy. Here's my take, for what it's worth:

• Market trends & inventory: of course, the ideal company is one that has no inventory, and yet can keep up with demand. If you're selling pure IPR, like chip designs (e.g. ARM), that's great, because inventory becomes someone else's problem. In the case of a software company (assuming its products are sold for download, or online use, rather than on shop shelves), inventory perhaps becomes synonymous with how much server capacity you have, plus possibly support staff. Hence, using cloud computing services such as Amazon's EC2, (or their content distribution network, CloudFront) and outsourcing non-core work to contractors (as suggested by Seedcamp's Reshma Sohoni) provides much greater flexibility to respond to demand. Of course, reading market trends hopefully means that you're aware of what proportion of your services are "base load" and hence could be performed in-house.
• Product strategy: be prepared to admit that your first idea didn't work, but that a part you never envisaged could be valuable actually might be. Concentrate on your core competencies.
• Market characterisation: talk to your potential customers! I find it incredible that there are so many web sites that make it so hard to give good feedback once they're selling (and that's after they've decided on their product!). As David Langendries pointed out in a comment on my post "The Dangers of Online Feedback", companies would do well to pick up the phone. Most successful products are preceded by good marketing (distinct from advertising), says Seth Godin. Which to me, means that technologists need to be very sure they can convince the customer that their product solves a problem that the customer (maybe) never realised they had. And convincing means talking, rather than yet another online survey.

So there you have it: terribly simple, right? ;-). Then again, you'll find plenty of other conflicting advice elsewhere. Over at OnStartups, Jason Cohen suggests that instead of trying to figure out which strategy is best, given that conflicting ones have produced equally successful companies, perhaps you just need to buck conventional wisdom (and hence not copy 37signals or Fog Creek)... Thoughts?

The Dangers of Online Feedback

Business Week has a very interesting book excerpt from "What Would Google Do?" (Jeff Jarvis), titled "Detroit Should Get Cracking on its Googlemobile", which caught my eye, in part, because I'm currently reading Tom Vanderbilt's "Traffic: Why We Drive the Way We Do (and What it Says About Us)". Jarvis points out that at present auto manufacturers don't really communicate with their customers about what they would like, or allow them to customise their cars in any meaningful fashion. If they had, he argues, we would have had ways to interface our iPods with our car radios long ago. In the future, if they treated cars as a platform that allowed users to create their own cars, we might see unpainted cars being sold, then taken to local graffiti artists. All hail "open-source" (?!) cars, apparently, not to mention open-source urban planning.

That got me thinking. Many large corporations are today accused of not listening to their customers. Meanwhile many are trying to use the Internet to change that (take a look at Get Satisfaction). It used to be that to listen to your customers involved conducting telephone or paper surveys, or paying people to be in focus groups. Now you can just set-up an online forum, or blog about your ideas and see what comments come back. In many ways that's good: the cost of soliciting feedback is minimal, so even one-person startups can do it. The bad bit is that the company has to take the time to actually listen.

Whilst older companies have a reputation for not asking for feedback, it seems to me that the newer technology companies have a bad history of actually listening to feedback that concerns policy. That's distinct from feedback on software bugs, which are effectively win-win for the company and the consumer. Google, for example, is great at releasing its products in beta versions, and fixing them up in response to feedback. However, looking at the upset surrounding its retention of search logs, and it's the opposite. Similarly, Facebook's introduction of its Beacon technology, for publicising what purchases users had made, didn't really go down that well either, though they at least made the service an opt-in feature after about three weeks. (Any other examples?) The point is not that users aren't eventually listened to, but more that they're listened to quickly or completely only when the company considers it to be commercially sensible.

"So what?", you might ask, "Isn't that obvious?" Well, to a company, yes. Pandering to users whilst potentially cutting your revenue or effectiveness doesn't seem commercially sensible. But if consumers now expect this easy-feedback channel to be taken notice of, then when it's not, a revolt occurs. On the web, where the switching costs tend to be lower, customers might just decide to go elsewhere. Even with companies who produce more tangible products (cars, say), users can still make a fuss very publicly, and very quickly. Worse, they'll accuse the company of "not listening". Suddenly the feedback channel isn't so great any more. Particularly since a lot of that feedback is public for all the world to see.

So, as a small company, online feedback can be great for understanding how to shape something new. But it's perhaps important to manage users' expectations. Otherwise you might end up like Face Party, who closed shop for a while after users complained that they hadn't been given what they'd been promised. Moreover, dedicating time to making sure that the online feedback channel is tended to, so that you at least appear (!) as though you're listening will probably pay off.

Welcome to a brave new world, where goodwill is generated by listening, rather than another PR campaign. Oh, and where trying to fake reviews to gain goodwill will probably be discovered.