Selecting the Appropriate Legal Entity for Your Technology Startup
In our role as attorneys representing emerging growth technology companies, we spend a lot of time talking to and working with entrepreneurs as they prepare to start new companies. This is the second in a series of five articles that will explore some of the legal and practical business issues that aspiring entrepreneurs need to understand as they begin this process. We understand that a lot of this information is dry, but there is some basic blocking and tackling we need to discuss before we get into some of the more interesting topics.
Picking up where we left off last time, now that you’ve made the decision to leave your job and put all of your energy into your new business, one of the first decisions you need to make is how to formally organize your business. Putting a legal entity around your new business is important for a number of reasons, including:
- personal asset protection;
- ease of transferring ownership (such as in the event of a sale of your business);
- having the ability to compensate and properly incentivize employees; and
- preparing you to (potentially) raise capital.
The vast majority of aspiring venture-backed technology companies are formed as a corporation for the reasons we will (painfully) elaborate below. Keep in mind, however, that every situation is unique and should be discussed with your attorney to determine which structure is right for you and your business.
So, without further ado, a breakdown of the four most common legal structures is below. I’ve listed them in descending order of desirability for a typical emerging growth technology company, and included some of the pros and cons of each:
A corporation is the most common legal entity utilized by emerging growth technology companies for a variety of reasons including the limited liability protection afforded to stockholders (i.e. you as founders) and the ease by which ownership may be transferred from one person to another. The corporation is also the corporate entity of choice for the sophisticated investors (i.e. venture capitalists) that you may one day wish to partner with.
- Limited Liability – Stockholders are not personally liable (other than in certain extraordinary circumstances) for the debts or other claims (lawsuits) that may arise against the corporation.
- Transfer of Ownership – Corporations are distinct from their owners and can survive changes of control (sales of stock on the stock market).
- Employee Benefits – Think stock options. Your employees understand how these work and will likely expect to receive them as an incentive to spend 20 hours a day coding in a dark room fueled by Red Bull.
- Capital Raising – Just as your employees understand stock options, investors—particularly venture capitalists—understand how corporations work and what it means to buy stock. More on what types of stock investors will purchase from you in my next article.
- Tax Inefficient – You will often hear reference to the double taxation of a corporation. A corporation is treated as a separate entity for IRS purposes and is responsible for paying income taxes each year. Any profits which are then passed on to the owners of the corporation as salary or dividends are then taxed as income to that stockholder as well, hence the “double taxation.” It is possible to avoid double taxation by filing to be an “S” corporation with the IRS, however, there are certain limitations on “S” corporations that will apply including the inability to have entity investors (i.e. no venture capitalists).
- Legal Formalities – Corporations are creatures of statute—each state has its own code of rules and regulations that apply to corporations.
- Cost – Corporations are expensive to form and maintain. In order to receive the limited liability protection of a corporation, certain corporate formalities must be followed.
Limited Liability Corporations (LLCs)
A LLC is a hybrid between a partnership (discussed below) and a corporation. LLCs are very popular for professional service providers like law firms, accountants, consultants and other entities in which the owners are looking to receive limited liability protection for their assets in a tax efficient manner. Many founders start their companies out as a LLC since the initial formation costs are low, and then convert to a corporation as their business matures and their needs become more sophisticated.
- Limited Liability – LLCs offer the same limited liability protection as a corporation.
- Tax Efficient – LLCs are a pass-through vehicle, meaning that profits and losses are not taxed at the entity level; instead they pass through to the owners directly.
- Flexible – Unlike a corporation whose operations are governed by statute, a LLC is a creature of contract, meaning that within some limited framework of regulations, the LLC can be managed in whatever manner agreed upon by the owners. This often results in unique voting requirements to approve certain types of transactions, or unique allocations of gains and losses to the members (i.e. other than evenly among the owners based on ownership percentage).
- Cost – LLCs are inexpensive to form and maintain largely as a result of the lighter statutory requirements.
- Capital Raising – Most venture capitalists or other institutional investors will not invest in a LLC. These can be an effective vehicle for certain individual angel investors, however, the more sophisticated angels will generally have a strong preference for a corporation.
- Transfer of Ownership – LLCs, while generally tax efficient, can result in certain issues on exit events that can complicate the process (the specific details of which we will leave to our tax practice area).
- Employee Benefits – Most of your prospective employees understand and expect stock options. That concept does not translate well to LLCs and can frustrate your ability to attract and retain highly qualified personnel.
A partnership is similar to a LLC in that it is a creature of contract rather than statute. Unfortunately, partnerships do not offer the personal asset protection or ease of transferring ownership that corporations and LLCs afford and for that reason are very infrequently used.
A sole proprietorship is the simplest structure, since there is no actual formal structure—you and your business are one and the same. An example could include a developer who creates and releases an iPhone application under his own name, where he would then be the sole proprietor of that business. Sole proprietorships offer maximum control since there are no special rules or regulations which govern how you run your business. They are also very tax efficient—you and your business are taxed as one and the same. Unfortunately, as with partnerships, you will have unlimited personal liability. Sole proprietorships are also extremely difficult to sell since the business is so closely tied to the owner.
To recap, there are many issues to consider when forming your business (even if many of them just aren’t that exciting). But the smart decisions you make on day one can pay dividends for you down the road. Do yourself a favor and do it right the first time.