In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.
Perhaps the most important early question facing the start-up entrepreneur is simply “what is it that you want this enterprise to look like”? We’ll be discussing boards, officers, equity, contracts, and other organizational questions in more detail later in the series, but the most fundamental of these is whether the entity should be organized as either a corporation or a limited liability company (“LLC”). (While there are other forms, they are usually only pertinent to the most special circumstances.)
The entire history of these two business forms is too dry and impractical for a full recitation here, so I will instead summarize only the bits most important to informing a modern-day decision. If interested in more of the history, I do recommend the wikipedia articles on both. You can find them here and here. They are “mostly” accurate, as are many things on wikipedia, though with some less than legally useful editorializing.
The corporate form is centuries old, arising out of both British and American common law and statutory traditions. A corporation is a legally recognized entity separate and apart from the individuals that operate it, and to which the government agrees to limit investor liability solely to the amount of money invested. It is staid, it is traditional, and the jurisprudence surrounding it is well-traveled ground that the nation’s investors understand (or believe that they understand) well.
By comparison, the LLC is the “new kid on the block”, really only coming into prominence in the 1990s. Like the corporation, it is used to protect its investors from liabilities greater than their level of investment. Unlike the corporation, it sits halfway between the freewheeling world of partnership law and the more tightly confined strictures of corporate statutes. An LLC can be organized in almost any manner imaginable. As a result, the laws and interpretations of laws surrounding LLC operation are not entirely settled (though this state of affairs lessens with each passing year).
So one is old and traditional, the other “new” (in legal terms) and flexible. What then drives decision-making for the start-up entrepreneur? In short, it is what they are looking for.
The first question is arguably the most fundamental:
How important is flexibility?
A standard for-profit corporation must have a certificate (or articles) of incorporation, bylaws, stockholders, a board of directors elected by those stockholders, and officers appointed by that board. Economics and voting rights generally flow directly through the ownership of stock (or series of stock) held by investors, and hundreds of rules are specified by statute on how the corporation must (and can) be run. In other words, everyone looking at a set of corporate records knows (about) how the entity they are reviewing is structured and how it may be operated at its most basic level.
By comparison, an LLC is governed almost entirely by a single document: the operating agreement. Such document can specify that investor A is to receive all the voting power and none of the income, investor B is to receive all of the income and none of the voting power, or just about anything (and I do mean anything) in between. Do you want a board of directors? No? Then get rid of it. Do you want officers? No? Then go without. Want tiered voting rights based on the fiscal quarter and the date of FDA approval of the company’s proposed medical device? Complicated, but you can do that.
The most prominent state LLC statutes, unlike their corporate counterparts, give ultimate precedence to the investors’ “freedom of contract”. That means that, all other things being equal, the state will honor whatever oddball provisions LLC investors decide to sign up to. It also means, however, that the courts (and potential investors) have a lot more to interpret when they are considering how an LLC is structured. This additional “work” can make raising capital harder for the “oddball” LLC.
But flexibility is only part of the story. Next week we’ll go into more specifics on other drivers here. In particular, we’ll discuss the importance of maintaining “corporate formalities” and the lesser requirements of the LLC form in this arena, the legal costs associated with setting up and maintaining each, the tax consequences of pass-through vs. double-layer taxation, the role of institutional investment in making the decision, and the exit hatch that is conversion statutes.
As always, if you’d like to discuss please leave a comment down below or contact me at www.hoeglaw.com. I’d love to hear your thoughts.