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Selecting the Appropriate Legal Entity for Your Technology Startup

March 11, 2009

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:

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:

Corporations

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.

Pros

Cons

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.

Pros

Cons

Partnerships

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.

Sole Proprietorships

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.