If you are reading this, you have finally had that ‘light bulb’ moment and are ready to take the plunge into entrepreneurship. Congratulations! This is sure to be one of the most exciting experiences of your life and you will certainly learn more than you ever imagined from this journey. You will face numerous challenges but if you keep your passion and determination alive, you will succeed, or at least come out of it stronger, smarter, and more likely to succeed with your next big idea.
Putting aside my vague words of congratulatory encouragement, let’s move to the first practical consideration you will face: what legal form should you choose for your startup?
The answer, like most legal answers, is “it depends”.
Since there is a wealth of information about this topic online (I provide URLs throughout this post that point to the most helpful sources I’ve found), I am going to write this post to explain why, for internet entrepreneurs (like myself) who expect to receive venture-backing sometime in the near future, a Delaware C corporation is, in my view, the best choice.
First let’s review the options.
1. Sole Proprietorship or Partnership:
I’m lumping these two forms together because neither will be desirable for you if you want protection from personal liability – a major reason to choose a legal formfor your enterprise in the first place. A sole proprietorship simply means that you, and you alone, run your business, with no legal distinction between you and thebusiness. You can think of a sole proprietorship as what you would be doing if you did not choose a legal form and operated the business alone. You are personally liable for all liabilities or debts that the business faces. In other words, if your business gets sued, your personal assets (not just the business’ assets) will be up for grabs.
A partnership can be thought of the same thing as a sole proprietorship, except with two or more people. This means that a partnership agreement is necessary, which specifies how profits and losses are split between the partners, what happens when a partner leaves, how to bring on new partners, each partner’s rights, etc. However these issues are decided, the important issue to note is that there is no separation between personal and business liabilities in a partnership.
In conclusion, although sole proprietorships and partnerships are easy to create and require minimal work to set up, neither are desirable for a startup that looks to raise outside capital since most investors will not be interested given the unlimited liability
An LLC or ‘Limited Liability Company’ does indeed, as the name implies, provide for a limitation on personal liability (unlike sole proprietorships or partnerships), which is great. LLCs also allow for considerable flexibility compared to corporations – you’re pretty much allowed to specify the ownership rights, responsibilities, and other details however you’d like to in your operating agreement. Finally, LLCs (like sole proprietorships and partnerships) allow for “pass-through” tax treatment, meaning that profits and losses are listed on each owner’s individual tax returns, which is typically a good thing.
So what’s the problem?
One issue with LLCs are that they are often burdensome to form – for example in New York, you need to comply with numerous filing and reporting requirements. Furthermore, LLCs can be EXPENSIVE to form — in New York, you must use the New York Law Journal to publish the formation of your LLC and this may cost up to $2000!
However, the bigger issue is that if you anticipate raising venture capital, almost no investor will invest in your company if it is an LLC. See Hank Heyming’s post for more on this .
When I worked at a major Silicon Valley law firm as a summer associate, a lot of the work I did involved converting LLCs into Delaware C Corporations, because the VCs insisted on it. This conversion work cost startups a lot of money, which they could have mostly avoided if they had chosen a Delaware C Corporation from the beginning.
3. S Corp
S corporations are significantly more complicated than LLCs from a tax and legal standpoint. Although there are significant tax advantages (particularly for businesses with a sizable income) to forming S corps, VCs also tend to avoid S corps the same way they avoid LLCs.
4. C Corp
C corporations are the preferred legal form for venture capitalists, and are actually relatively straightforward to form. If you choose Delaware, the preferred state for most VCs since it has the most straightforward legal precedents and rules which everyone is familiar with, you basically just need to:
a. Choose a registered agent in Delaware – we at Sportaneous use Incorporating Services Ltd who we have been very happy with.
c. Issue the appropriate number of shares to each founder, leaving a portion of the authorized shares in the company treasury to form an option pool or just to reserve for the future.
Suggested Resources for Further Reading: