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.
This post is a continuation of our discussion on the differences between corporations and LLCs (if you missed Part I, check it out here). Note: As I did not want to split this discussion up over three weeks, this post is a bit longer than most.
How likely are you to follow “corporate formalities”?
One of the primary purposes of setting up a new business entity (rather than just operating as a “sole proprietorship” or similar “individual” form) is to protect yourself and your investors from liability for the actions of that entity. As I tell it when giving presentations on forming a business: you set up a corporation (or an LLC) to prevent someone from seizing your house if your company gets sued.
Unfortunately this protection only takes maximum effect if the managers of the entity are able to follow what are known as “corporate formalities”. This means documenting the actions of the company properly, making sure the finances of the company are kept separate from the finances of the individuals involved, and ensuring that, in every way possible, the “legal fiction” of the existence of this “thing” separate from its owners is maintained. Failure on these points can result in a court “piercing the veil” of the entity to ascribe liability to its owners instead. In other words, if you don’t follow the rules, someone just might be able to seize your house.
While in every case my recommendation is to follow the requirements of such formalities to the letter, the truth on the ground is that some folks are more detail-oriented than others. An important part of early discussions then is informing my client of what is to be required of them in maintaining their chosen form. In short, while both corporations and LLCs require you to keep your finances separate, to sign as the entity in question, and to otherwise not confuse the entity’s assets with your own, the corporate form also imposes additional requirements such as annual meetings, board elections, and other documentation. An LLC, by contrast, generally doesn’t have to require those things (but may choose to do so to strengthen its case on separate existence, if desired).
So if a client desires to avoid the extra requirements of the corporate form (or believes it will be difficult or costly to comply with them), forming an LLC becomes a more attractive option.
How much do you want to spend on legal, accounting, and other professional costs?
One of the most popular questions I receive on any topic really, is “What is this going to cost?”. As you (and my clients) might be getting sick of hearing already, the answer is usually “It depends”.
As mentioned above, the corporate form is the more standardized form. It has more specific requirements and along with those requirements generally more documentation to be drafted, organized, and maintained. After all, if you’re an LLC and don’t need to have a board, or annual meetings, or corporate actions, there is very often nothing to draft, let alone anything to have separately signed or organized in the company’s books and records.
It might seem counter-intuitive then, but the corporate form is also often the cheaper alternative in terms of legal (and other professional) costs, especially when it comes to formation. That is because of the aforementioned flexibility of the LLC form. When I talk with my clients on the issue, I state one basic rule: There is nothing more expensive to ask of a lawyer than for them to draft a “novel” document or set of provisions. In other words, like most professions, the practice of law is based on precedent; learned knowledge and documents that the lawyer in question has drafted or reflected upon in the past and of which he or she can now revise or use to meet present needs.
If your LLC is going to be managed by three tiers of management committee with separate powers each of which will be entitled to separate economic rights in a 14-step waterfall, you may be perfectly aligned in your incentives, but chances are I haven’t structured something like that before and you will wind up paying me (or other legal counsel) for hours of work to make sure your scheme is drafted correctly and as protective of you as possible. By contrast, a corporation may require 7 or 10 separate documents to spring into being, but those documents are generally of a similar nature each time.
As with all things legal, the answer will depend on your specific needs.
What is the likely tax situation of the Company (and its investors)?
Corporate taxation is rather infamously known for the fact that income received by a corporation is taxed both when received by it, and then again when such same income is distributed to its investors. Avoidance of this “double taxation” effect, in fact, can largely be thought of as responsible for the creation of the LLC form in the first place. By comparison to a corporation, an LLC is, by default (more on that below), taxed as a partnership. The income of the company, in other words, is immediately attributed to the owners of its equity in whatever manner and proportion set forth in the LLC’s operating agreement (though certain tax conventions are certainly advised).
While the LLCs “single tax” structure may initially seem uniformly advantageous, it is not always so. Depending on, among other things, the various rates of taxation in play in certain jurisdictions, the corporate tax rate at the time, the likelihood of the entity’s receiving income or recognizing losses during its first few years in operation, and the desire (or lack thereof) of the founders of the company to distribute assets out of the entity to provide for the owners’ tax liabilities, it is possible that “stopping” income at the corporate level could be advantageous. Every group of founders and investors will be different on these questions, and legal counsel should work closely with the proposed entity’s accounting and tax professionals to organize the entity in a way that is most advantageous to all involved.
Note further, that the tax discussion itself is a bit of a red herring in some respects as an LLC can elect to be taxed as a corporation, and a corporation (through the election to become an S chapter corporation with the IRS) can elect to be taxed as a pass-through entity (provided it does not have institutional investors). That said, there are limitations and disadvantages to both approaches, so, all other things being equal, the default of LLC = pass-through, corporation = double taxed, is a useful shorthand on the subject.
Are you expecting to need institutional investment?
As was the case when we discussed where to form your entity, the question of what kind of entity to form can be driven in large part by what funding you expect your new enterprise to require. If you are largely bootstrapping your company with funds of the founders (or of the founders’ friends and family), the world is open to you. Be a Hawaii partnership, Michigan LLC, or anything in between. If, however, you intend to seek financing from institutional investors shortly after formation, you should expect to be a Delaware corporation before such financing occurs. There are exceptions to this, but they are rare.
The simple fact is that the flexibility afforded to the LLC form is a detriment to an institutional investor’s ability to assess risk and to understand the way your entity is organized and operated. Because of that, all other things being equal, an investor would prefer to invest in a corporation, because, in short, “it knows what it is buying”.
If necessary, conversion allows you to change your mind
As was the case in our discussion of an entity’s “domicile” (if you missed it, check it out here ), the states’ conversion statutes are useful to correct any “mistakes” you might have made in selecting your form of entity. In fact, though I state that institutional investment prefers Delaware corporations above, it should be noted that I have been involved, on both the Company and Investor sides, with negotiating institutional financings of Michigan LLCs, Nevada corporations, and the like. It is simply stated as part of the terms of those financings that the entity in question must convert to a Delaware corporation as a “condition precedent” to getting the Investor’s money.
It is because of the presence of the (relatively) simple conversion process that I often recommend to clients that they form whatever entity (and in whatever domicile) they think fits them best in the moment, and to not over think or try to arrange their entity in whatever way they imagine some future investor might desire. The fact of the matter is that, if a future investor comes along, they’ll be reforming the organization to their desire anyway.
As you can see, there are a fair number of considerations to take into account when deciding on what kind of entity you wish to form (and where to form it), and the issues described in this and last week’s post are only some of what may arise when you try to put your company together. As you might expect, I recommend that any new entrepreneur find good legal counsel to help aid them in the process.
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.