Selecting a Corporate Structure for Your Startup Venture
The following article appeared in the January 2010 issue of the Flathead Business Journal, but is no longer available online.
Sole proprietorships are the most common form of business ownership. A sole proprietorship is an unincorporated business owned by one person. The most important feature of a sole proprietorship is that the law makes no distinction between you, the sole proprietor, and your business. If operated as a sole proprietorship, your personal assets are at risk in the case of a failure of the business or a successful lawsuit against the business by a customer, employee, partner or other. It is this risk exposure that drives entrepreneurs to form a state-regulated business entity, in which the owners, both founders and investors, are shielded from most liabilities incurred by the corporation.
A general partnership is an entity which defines the ownership of assets but does not provide a liability shield to the owner/partners. Tax liabilities are also passed through to the partners. Because partnerships provide no more protection from the liabilities of the business than do sole proprietorships, they are not a recommended structure for startups.
Most startup entrepreneurs choose to establish either a Limited Liability Company (LLC) or a corporation. An LLC is a hybrid entity in which the owners are shielded from most of the company’s liabilities but, for tax purposes, the LLC is generally treated like a partnership. Taxable income and losses are passed through to the owners. No taxes on earnings are due from the LLC.
A corporation is the classic form of entity used by private and public companies alike. A corporation can be taxed at the entity level (a “C” corporation) or can elect to be taxed as a partnership (an “S” corporation). The tax status of a corporation is determined with the IRS. State corporate law makes no distinctions between C and S corporations.
S corporations, which are corporations that elect to be taxed similarly to partnerships and LLCs, provide liability protection for their shareholders’ other assets. The biggest problems with using S corporations as the entity of choice are that (1) they are limited to 75 shareholders, (2) they cannot have other entities (except certain qualifying trusts and tax exempt entities) as shareholders, (3) they cannot issue more than one class of stock and (4) they cannot have foreign nationals as shareholders. Because the LLC structure is more flexible in design and use than an “S” corporation structure, the “S” corporation is not commonly chosen by entrepreneurs today.
For entrepreneurs who are starting companies with their own cash and resources, LLCs are often the structure of choice. LLCs offer many options in design and utilization and have become very popular in the US. However, some angel investors and most venture capitalists will not invest in LLCs, insisting instead that the company be organized (or reorganized) as a “C” corporation at the time of investment, because “C” corporations allow multiple classes of stock. These investors usually insist on investing in preferred stock while the founders and management team own common stock in the company, for the following reason:
- In the case of corporate liquidation, the preferred shareholders generally “stand ahead” of common shareholders; that is, preferred shareholders may receive the amount of their investment back after liquidation before the holders of common stock get any return.
- Preferred shareholders often have certain other rights not afforded to common shareholders, such as dividend rights, liquidation preferences, and class voting rights for certain transactions.
- The preferred/common structure allows the Board of Directors of the corporation to establish a price for common stock options for the management team that is substantially below the most recent pricing of the preferred shares – and can be significant incentive for recruiting a qualified management team.
It is important to note that businesses are formed according to state laws but generally taxed according to both state and federal regulations. Consequently, these decisions are always best made using an attorney familiar with entity formation in the state in which the business will operate.
For businesses that require substantial sums of money to be successful (greater than $2 million, for example), the entrepreneur may choose to incorporate in the State of Delaware. Venture capitalists and other sophisticated, deep-pocketed investors will likely insist on Delaware for incorporation because the state’s robust case law offers a predictable and shareholder-friendly legal environment. Again, consult with competent counsel in making these incorporation decisions.
Entrepreneurs may consider forming an entity immediately, if they need to protect intellectual property rights or raise capital. It is my suggestion, however, that entrepreneurs not rush into choosing a corporate structure until the company begins hiring employees and generating revenues. Take your time and carefully select the corporate structure that will best fit your needs over the long haul. Forming a business entity requires the expenditure of both time and cash, which might be better spent elsewhere as an entrepreneur begins thinking about starting a company.
Disclaimer: The author is not an attorney and urges readers to seek professional counsel before choosing a corporate structure for their startup businesses.
Acknowledgment: The author appreciates the comments and suggestions made by Jeff Heutmaker, Esq. (Polson, MT), firstname.lastname@example.org, www.heutmakerlaw.com, in the preparation of this column.