- Posted on: Dec 29 2021
By: Wright Lewis
December is the time of year when people reflect on the year gone by and begin setting goals for the year to come. For many people, this process of reflection and goal setting will result in a resolution to step out of their comfort zone and finally start a company that will be the vessel to bring that great idea they have been tinkering with from concept to reality. To launch a successful business, the aspiring entrepreneur should be careful not to overlook the not-so-exciting but important process of establishing a legal entity and governance structure appropriate for their aspirations. The following is a brief overview of important considerations for entrepreneurs launching a new venture.
Entity Selection and Formation
The primary reason to form a business entity is to limit the liability of the company’s owners for the debts and obligations of the business. Such liability is generally limited to the amount invested, with some caveats. There are various entity types that can limit your personal liability as a business owner, including corporations, limited liability companies, and limited partnerships. Even if the business is owned by one individual, it’s so cheap and easy to form an entity that the benefits greatly outweigh the costs. Additionally, a separate legal entity is necessary if the business has or may have co-founders, needs to raise capital from investors, or plans to share equity with employees.
The type of entity and the jurisdiction where it is formed will depend largely on what type of business the entrepreneur is launching, including factors such as how the company will be managed and the type of tax treatment desired. The two primary types of limited liability entities formed in the U.S. are corporations and limited liability companies (or LLCs). A corporation can best be thought of as an off-the-shelf option for a business entity, with very specific rules and boundaries that are largely governed by the corporate laws of the jurisdiction of incorporation. The corporate structure provides predictability for all stakeholders (directors, officers, and shareholders) due to its rigid structure, long history, and extensive case law. A corporation can elect to be taxed as an S corporation under the Internal Revenue Code if desired. The LLC is a much newer form of limited liability entity, originally created in 1977, but not widely used until the last few decades. LLC’s are now the most widely used form of limited liability entity. They are easy to form and have significantly more flexibility in governance and taxation than corporations, as further detailed below in “Governance.” A single-member LLC is a disregarded entity for tax purposes (unless it elects otherwise), so its profits and losses are attributed to its sole member. Multi-member LLCs receive partnership taxation by default, but an LLC can also elect to be taxed as a C corporation or S corporation if preferred.
Generally speaking, if the business will be capital intensive and require significant amounts of money to be raised from institutional investors like venture capital firms, then it is usually appropriate to form a Delaware corporation. Professional investors are used to investing in Delaware corporations, and they value the legal predictability and tax structure of the corporate form. If a company is not a Delaware corporation, many investors will require that the company convert as a prerequisite to investing. When forming virtually any other type of business, an LLC formed in the jurisdiction where the business is located is usually the most appropriate option.
It is important to note that, regardless of entity type, in addition to its jurisdiction of incorporation, a company must also register as a “foreign entity” (an entity formed outside of the subject jurisdiction) in each state where the company transacts business. Each jurisdiction has its own specific rules regarding what constitutes “transacting business,” but in general, transacting business includes having (1) a physical presence in the state (office, store, manufacturing facility, etc.) or (2) employees who live or work in the state. States also have varying thresholds related to the number or value of sales made in the state, which also constitute transacting business in the state and often includes sales made online to residents within the state. These rules are important not only for registration purposes but also for labor and employment and sales tax obligations and should be taken seriously. Failures related to withholding and tax obligations are not afforded limited liability protection and can become personal liabilities of the company’s owners.
Once an entity has been formed, the founder(s) must establish the governance structure for the business. If the entity is a corporation, the governing documents will consist of the Bylaws, resolutions of the shareholders and the board of directors and, depending on the specific facts and circumstances of the business, may include a shareholders’ agreement, stock purchase agreements, voting agreements, and various other ancillary agreements that supplement the corporate code of the state of incorporation. The provisions of the corporate code must be strictly adhered to and are often consulted in conjunction with the Bylaws and other governing documents established for a corporation. If the company will need to raise capital from institutional investors, each founder should execute a stock purchase agreement requiring vesting of their shares over time and repurchase of unvested shares upon termination of service to the company, along with restrictive covenants related to confidentiality, intellectual property, and nonsolicitation/noncompetition.
In contrast to corporate governance, an LLC’s management and governance can be almost entirely controlled by the terms of the company’s operating agreement. The operating agreement will generally override the default rules contained in the state’s LLC act, providing extraordinary flexibility for the founder(s) to structure the business as desired. There are virtually unlimited combinations of terms that can be included in an operating agreement, but founders should carefully consider and include provisions addressing who will be vested with the authority to manage the day-to-day affairs and major decisions of the business, rights, and obligations of members holding a majority and minority of the membership interests, allocation of profits and losses, redemption of interests of departing members, confidentiality, intellectual property, and nonsolicitation/noncompetition, indemnification, and dispute resolution.
The right co-founder(s) can be invaluable. They can provide a sounding board for ideas, complementary skills, division of labor, and the difference between success and failure. However, regardless of how long or how well co-founders know each other, or how great of a fit they may seem, it is vitally important to establish from the beginning each founder’s expectations about division of labor, ownership, and management of the company, and to prepare and execute appropriate governing documents reflecting their mutually-agreed-upon expectations. It is said that people regret that which they did not do, more than that which they did. If you are contemplating starting a business, be sure to take advantage of the financial and legal resources available to you.
Posted in: Business Law