This is a first of a series of short articles I am writing to help budding entrepreneurs get started with their startup.
For most startups, it is important that you form a legal entity as soon as possible. Operating your business through a legal entity helps to avoid any personal legal liability for business debts and liabilities. Without forming a legal entity, your default status is that of Sole Proprietorship (if you own and operate a business by yourself) or a General Partnership (if you own and operate your business with one or more individuals). In either case, you would have unlimited personal liability for the obligations of the business.
In addition, setting up the entity properly and as soon as possible helps avoid future disputes over IP and equity ownership. It is not unusual for individuals who are involved in the early ideation phase of a business to drop out or be pushed out of the business. If you haven’t set up a legal entity, transferred the relevant IP to the entity and issued the founders stock, you face a significant risk of future disputes as well as a significant risk that a potential investor may be scared off from making an investment.
There are essentially 3 choices to forming your company: S-Corp, LLC or C Corp. You should consider setting up an S-Corp or an LLC if you are planning on investing your own business and would like to benefit from the early losses from your startup. Once you start generating a profit, you will also avoid double taxation. However, note that no VC will invest in either an S-Corp or an LLC as they don’t want to deal with pass-through income. Also, only shares in a C-Corp will qualify for QSBS (Qualified Small Business Stock). There are substantial tax advantages of having the QSBS designation once you sell your shares.
Between an S-Corp and an LLC, an S-Corp is a better option. It is less expensive and less complicated to set up. With an S-Corp, you can have only one class of stock so you can’t use an S-Corp to create a preferred share class to accommodate investors. However, you can easily solve that problem by raising funds as a note — your investor’s funds are treated as debt and not as equity requiring a special share class. With an S-Corp, you can also issue ISOs (Incentive stock options) whereas with an LLC you cannot. It is also easier to convert an S-Corp to a C-Corp. Note that with an S-Corp, the shareholders need to be US residents.
Once you are ready to raise funds from VCs, you will need to convert an S-Corp or an LLC to a C-Corp. However, your law firm can easily handle this conversion at the point at which you raise funding.
A final note, you should register your company in Delaware. This is a requirement for most VCs and Delaware has well established regulations for dealing with corporations.