Business Formation Considerations for Start-Ups and Emerging Companies

As corporate attorneys, we come into regular contact with new businesses and have the opportunity to watch as ideas evolve into products, services and creations that better serve society. We also are acutely aware of the challenges that lay ahead for entrepreneurs in transforming their ideas into a company or product. As staunch supporters of entrepreneurs who want to transform their ideas, we decided to band together and create a preliminary discussion on best practice strategies that start-ups and emerging companies can easily leverage. The result of that work is The Start-Ups & Emerging Companies Guidebook. The following is an excerpt from that guidebook.

Great ideas can take many different forms. Maybe it’s a simple solution to an every-day problem, or perhaps an idea that will turn a stagnant industry upside down, or maybe it’s just something you’re passionate about.  Congratulations – that’s the first step. Now, it is time to form your company. There are many aspects to company formation including entity selection, governing documents, and the composition of ownership and management.

ENTITY SELECTION

Entity choice is a critical decision to make when forming a company. The four most common entity types are (1) sole proprietorships, (2) partnerships, (3) limited liability companies, and (4) corporations. Depending upon your business objectives, a certain entity type might be more or less advantageous. For example, entity choice can impact whether an owner’s liability is limited, the extent to which an owner can participate in the management and operations of the business, tax matters, and the amount and what type (or number) of outside investors are permitted. Due to these complexities, it is recommended that tax professionals be consulted and to work with your legal team in the entity selection process.

Although discussed in some detail below, generally neither sole proprietorships nor general partnerships are recommended. In addition, professional corporations and professional limited liability companies are sometimes required to operate certain regulated business.

SOLE PROPRIETORSHIPS

Sole proprietorships are owned and operated by one person. For taxation purposes, they are considered to be a “pass-through,” meaning that the profit or loss from the business passes directly to the owner and is reported on the owner’s personal income tax return. A sole proprietorship is technically unincorporated and therefore treats the business owner and business as one and the same. On that basis, the individual owner is exposed to unlimited personal liability for any liabilities of the business. In other words, if the business is sued, the owner (and his or her assets) is responsible for satisfying the liability. In terms of business growth and potential fundraising, sole proprietorships do not permit outside investors. On that basis, if you intend to raise money from third party sources in exchange for ownership interests, you should consider alternative entity types, including any of the forms described below.

PARTNERSHIPS

Generally speaking, a partnership is an association between two or more people, typically governed by state law. Like sole proprietorships, partnerships are treated as pass-through entities for tax purposes unless the partnership elects to be taxed differently. However, because a partnership is owned by at least two people, the profits and losses of the enterprise are allocated equally between or among the partners, unless otherwise specified in a written partnership agreement. It is recommended that all partnerships, regardless of classification, have a written partnership agreement in place that sets forth the then-current ownership of the partnership, the governance and management of its business and the rights of the partners with respect to each other and third parties interacting with the partnership.

A partnership can either be a general or a limited partnership. A general partnership is a business or agreement (whether governed by a contract or not) between two or more partners, each of whom are obligated for the business’s debts, liabilities, and assets. A limited partnership is an entity created by the filing of a certificate with the appropriate state authority and is governed by state law. A limited partnership requires at least one of its partners to serve as the general partner, but in a general partnership all the partners are considered to be general partners. General partnerships provide little to no liability insulation to its partners. Conversely, a limited partnership offers liability protection to their limited partners, whose role in the business is typically limited to the making of their investment. As a result, the liability of a limited partner is limited to the extent of its investment in the partnership and a general partner is exposed to more substantial liability on behalf of the business and is not insulated from the partnership’s liabilities. If, at any point, a limited partner participates in the management and operation of the business, the partner may inadvertently become a general partner. Due to the governance structure and tax benefits of this entity type, limited partnerships are common vehicles for investment funds.

LIMITED LIABILITY COMPANIES

A limited liability company is an entity that is owned by one or more members, each of which can be either an individual, an entity, or a trust. A limited liability company can be managed by its members, a manager appointed by the members, or a board of managers appointed by the members, in each case, as specified in the organizational documents of the company. Similar to a partnership and a sole proprietorship, a limited liability company is considered a pass-through entity for tax purposes. As the name indicates, a limited liability company limits the liability of its members (and often managers) with respect to acts of the company, such that members are typically liable solely to the extent of their capital contributions to the company. It is highly recommended (and often required by state statute) that the members and/or managers of any business enter into and adopt a written limited liability company agreement or operating agreement to detail the ownership, governance, and operations of the company, and the relative rights, privileges, preferences and obligations of its members. Limited liability companies provide great flexibility in terms of equity structuring, governance terms, transferability of ownership interests, and buyout or repurchase rights. For that reason, the limited liability company is the entity of choice for a variety of different businesses, whether it be a large investment fund, a joint venture, or a closely-held business.

CORPORATIONS

A corporation is a distinct legal entity owned by a group of individuals or entities that are called shareholders. Corporations are typically governed by a board of directors elected by the shareholders, who in turn may appoint officers to operate the day-to-day business and affairs of the corporation. Unless expressly disclaimed, all corporations provide liability insulation for their shareholders (and often directors). There are two primary types of corporations for tax purposes, S-corporations (“S-Corp”) and C-corporations (“C-Corp”). 

A corporation may elect to be treated as an S-Corp for income tax purposes. In doing so, the S-Corp elects to pass corporate income, losses, deductions and credits through to its shareholders, permitting the S-Corp to avoid double taxation on the corporate income. However, S-Corps have stringent eligibility requirements that, if violated, can have adverse tax consequences to the entity and its shareholders. S-Corps can have no more than 100 shareholders, all of which must be permitted holders (i.e., individuals, certain trusts, and estates and must be citizens or legal residents of the United States). Most partnerships and corporations do not qualify as permitted holders, and financial institutions, insurance companies and domestic international sales corporations are specifically excluded. Finally, an S-Corp cannot have multiple classes of stock beyond a voting class and non-voting class. The foregoing restrictions make S-Corps a less attractive option (or a relative impossibility) for larger companies taking on a variety of investors.

A C-Corp is the default corporate form unless a specific election is made (as described above). C-Corps provide many similar benefits to the benefits available to other corporate forms, including without limitation, limited liability for shareholders and a structure conducive to raising capital funds.

However, corporations are generally more expensive to form and operate over time, and have far more requirements with respect to formation, reporting and governance formalities than other entities. Further, C-Corps present a double taxation problem – meaning that the corporation pays taxes, and then its shareholders pay personal taxes on any dividends received from the corporation. Notwithstanding the above, C-Corps are generally the preferred entity type for companies seeking to raise capital via multiple funding rounds from institutional investors, as institutions generally prefer to invest in a corporation (and certain types of investment funds are required to only invest in corporations).

To continue reading this article and learn more about entity formation and governance considerations, please access The Start-Ups & Emerging Companies Guidebook.