Thursday, August 5, 2010

Business organization for your startup

Thoughts from business experience.  For legal opinions, consult your attorney and tax accountant.

Do not start as a sole proprietorship
This is the only recommendation sure to have no dissenters. All else following is meant as a general guideline to use in questioning your attorney on the best course for your particular circumstance.

The LLC - quick, easy, inexpensive
Many would agree that on a minimal budget this is the best alternative to get limited liability protection cheaply and quickly.  Most states now have web sites where name availability may be checked and reserved, sample minimum articles of organization are provided, applications may downloaded and filed by mail.  If you are in business alone in most states you can be in business in a few weeks, for $100 or less, and have little else to worry besides doing business.  Your local SBDC or SCORE chapter will help you free of charge to get it done.

A more complicated picture
The picture of course gets complicated as soon as you propose to add partners and investors. These are my rules of thumb:

Operating Agreement (OA)
Also called Partners Agreement and other similar names, this not required to organize an LLC in many states, but it is required by common sense: If you have even a a single partner, spouse included, you owe it to yourself to have an OA that spells the rules of engagement: how key decisions are made: e.g. sale of the business, personal guarantee of loans, call for incremental investments from founders, approval of financial control processes, access to records, management compensation approvals, etc.
Most importantly you should agree in writing to how you will part ways if needed (spouses included) - who can buy out whom when and how, how to value the business, etc. To promote fairness, strive to implement the old "parting the cookie" technique " (one cuts the cookie, the other picks which half).  It is much easier to agree when you are friends than when you will want to separate, probably because of irreconcilable differences   If in this negotiation process you learn something about your partner and your partnership dies and untimely death, you won't be the first - better early and with less pain now, before committing time and treasure, than later.


Tax Liability
In most cases, with proper elections filed with the IRS, your LLC will not require separate income tax filings and members report their share on Schedule C of their personal return. Advice from an accountant will cost little and ensure no bad surprises - make it mandatory.

However, regardless of how taxes are filed, members will take the tax liability impact of the LLC's income or loss, so the Operating Agreement should include a requirement that cash be disbursed to cover the members' tax liability.  Otherwise you risk having a tax bill due with no cash to pay it.  Partners with very different financial postures may have very different perspectives, so agree in writing ahead of time.

Complexity increases further as the number of members and investors increases. In particular, outside investors, angels and VCs, are likely to have a very different tax exposure, cash position, needs and objectives from the founders.  Of late many attorneys advertise that an LLC can be set to be govern and to function internally as a C corp with the "proper" Operating Agreement.  Perhaps so, but in my experience managing the different needs with amendments of the Operating Agreement will  become cumbersome, costly and beneficial only to the attorneys.

Furthermore the flexibility of defining the Operating Agreement however one wants is a two-edged sword that impacts investors' due diligence workload and cost.  Corporations' governance is much determined by state statutes which local corporate lawyers know well.  LLCs with complex Operating Agreements require careful review because only what is written governs and what is written could be unusual or unexpected and whatever is missing may be litigated later. Many angel investors simply avoid this risk but investing only in a C corp.

Switching to a C Corp.
At some point, switching to a C corp organization may be a desirable option.  Professional advice from tax and corporate lawyers is mandatory.  Mistakes can have dire consequences.

If you come to this point, be prepared to encounter a painful reconciliation of diverging interests of the owners.  This will be particularly so if along the way some "family and friends" investors extorted or were offered a "non-dilutable" clause or "unanimous approval" of funding decisions or changes in organization.  You may have % majority interest, but veto power trumps and is costly to remedy and there may not be statutes to help you out.  In any event this step will require time, and the less time you have the more leverage the competing interests will have against you - allow plenty of time.

Starting as a C corp
This option is of course preferable if you can afford it and particularly if you start with a business vision that includes angel investors, VCs, many shareholders, IPO, publicly trading stock, etc.  In this case you'll face significant differences relative to an LLC including:

  • Higher organization costs
  • State corporate filing requirements
  • Income tax filing requirements
  • Corporate governance statutes 
Details on these points are beyond the scope of this post. However, with respect to tax liability management, in the early stages of your startup you may personally benefit from any tax losses by electing to have the corporation taxed as a partnership (S election). The election can be reversed (only once) later when you no longer benefit from that method of taxation or your corporate needs change (e.g. IPO).
With regards to corporate governance, I have mentored many a budding entrepreneurs (mostly MBAs) much concerned with "preferred states of incorporation" (e.g. Delaware, Nevada, etc.). I am certain a case may be made and supported for their relative advantages. However I subscribe to KISS: In all states there are thousands of corporations that manage to do business successfully subject to their local statutes.  Relative differences among states become relevant primarily in cases of proxy fights and similar circumstances which are unlikely to occur with a startup (you better figure how to avoid them).  Instead, incorporating out of your state of primary operation is sure to require additional costs such as for multiple state filings, "domestication" into the state where your head office is located, retaining a registered agent, and more.  In my view, when your business makes it to be part of the S&P Index and you develop high concerns for proxy fights, you'll have the cash to relocate it then whatever state is desired.

In the end all agree: avoid sole proprietorships.  Beyond that, be ready to adjust your corporate organization to match your budget requirements of your shareholders and investors.  

Marco Messina

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