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Start Ups and Emerging Companies – 101: Choice of Entity

January 14, 2013

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What type of corporate entity is best for my business?

As a founder/entrepreneur, you (and your partners) have an idea for a new venture are willing to invest your time and money in the start-up of a new business.  Selecting the right corporate vehicle  for your business is critical to your success.  The goal of the founder is to choose an entity that (1) "fits the business model" for the venture, and (2) makes the company "attractive" to investors.  How do you know what entity is the best fit?

A good starting point for making this determination is to ask yourself: "How am I going to fund my company?"

Many founders start their company with their own funds on a "shoe string", focusing their resources on developing the "big idea" and bringing the product to market.  However, after your "founder funds" are exhausted (self-funding), you will need to either sell your company, or seek investment from one or more of the following Private Equity sources:

The investment path you choose will pay a significant role in the corporate vehicle you select for your company.

What are the typical corporate entities to choose from?

Generally, there are three main types of entities to choose from: Corporations, Limited Liability Companies and Partnerships.

Corporations:  A Corporation is owned by its shareholders, who buy stock or shares in the company in exchange for consideration.  The corporation is governed by a set of bylaws which states how the corporation is to be operated.  The shareholders may decide to define the rights between them through a shareholder agreement.

Limited Liability Company  (LLC):  A Limited Liability Company  (LLC) is owned by its members (as opposed to shareholders) who have a membership interest (as opposed to stock) in the company.  The LLC is governed by an operating agreement which states how the company is to be operated.  The operating agreement also provides for the rights of the members with respect to the company, and in particular, the members' respective exit rights.

Partnership:  A Partnership is owned by the partners, who have a "partnership interest" in the partnership.  The partnership is governed by a partnership agreement which states how the partnership is to be operated.  The partnership agreement also provides for the rights of the partners with respect to the company.

So what is the best entity for me?  

First, a little bit about corporate entities.  All corporate entities are recognized as a separate legal entity.  This means that they exist as a separate "person", that can, for example, buy and sell goods, employ people, enter into contracts, and take any other action that any person can do.  Just like you and me, the liabilities of the corporate entity are limited to its own assets.  The founders are generally not liable for the debts of the company.  Also, like any person, the company pays taxes.

With this background, consider the following specific types of entities for your business.  This is not an exhaustive list, but are the most common business entities used for start-up ventures.

C-Corporation:  A C-Corporation is a type of corporation. If you are seeking Venture Capital funding, a C-Corporation may be the best fit for your business. Most corporations (and practically every large company) are organized as C-Corporations because they appeal to a larger group of investors.  Venture Capital firms generally favor C-Corporations because only C-Corporations may issue preferred stock and have stockholders other than individuals.  C-Corporations tend to be more formal and more expensive to operate than other forms of corporate entities.

The most significant drawback to a C-Corporation is the potential for negative tax treatment.  This "double tax", as it were, means that the corporation pays tax on its profits at the end of the year (reported on the company's income tax return), and when the corporation makes a distribution to the founders (and/or other shareholders), the founders/shareholders also pay tax (hence, a "double tax") on the distributed amount on their personal income tax return.  Many entrepreneurs want to avoid this "double tax" exposure.  There are ways to avoid "double tax" exposure for a period of time, but as your company grows, "double tax" will be inevitable for the successful C-Corporation.

Limited Liability Company (LLC): If you are seeking funding from Friends and Family or from Angels, an LLC may be the best fit for your business.  Many companies are formed as an LLC because an LLC not subject to "double tax", and it has the same limited liability protection as a Corporation.  In addition, an LLC may issue preferred membership units with the same privileges and rights as preferred stock.   Also, ownership in an LLC is not limited to individuals, but may include other corporate entities as members (owners) of the LLC.

While an LLC may be ideal for most Private Equity investors, Venture Capital firms typically avoid LLCs because they are taxed as a "pass-through" entity.  This means that the members pay the tax owed by the company directly on their personal income tax return. The company is not separately taxed.  Venture Capital firms typically do not invest in LLCs because this "pass-through" taxing mechanism may require that the firm (as a member of the LLC) report the company's losses to the firm's investors (which VCs don't like to do), or may require the firm's foreign investors to file a US tax return. 

LLCs, however, are frequently used for non-venture capital funding, such as Friends and FamilyAngel Funding and other Private Equity (e.g. Series A) rounds.  There are some additional cost considerations associated with LLCs which should be considered as part of your entity selection decision.

S-Corporation:  Similar to an LLC, an S-Corporation is a "pass-through" entity.  S-Corporations are somewhat limited, however, because the number of shareholders that the company may have at one given time is capped, and, importantly, the shareholders generally must be individuals.  Also, an S-Corporation may only have one class of shares, called common shares.  These features may be acceptable for a Friends and Family round of financing, but is generally not favorable for other types of Private Equity funding.

Partnership:  Partnerships are rarely used because they, for the most part, expose the partners to unlimited liability for the partnership's debts.  Enough said.

Bottom line:  If you have the next "twitter" or "you tube", then you may want to form a C-Corporation at the outset and position the company for substantial funding (and eventually an IPO).  However, if what you are looking for is flexibility, and an entity that is easy to use and easy to invest in for most Private Equity investors, an LLC may be your best bet.  If you decide (or an investor requires) that you later convert to a C-Corporation, the process to convert is relatively easy and generally not cost-prohibitive to accomplish.

 

For more information, please contact:

Derek Ridgway

925-746-8484 Direct Phone
925-746-8493 Fax

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