Startups: What Kind of Entity Should You Form?

By SUSAN LAHEY
Reporter with Silicon Hills News

David Valenti, a partner with Reed & Scardino, photo by Susan Lahey

David Valenti, a partner with Reed & Scardino, photo by Susan Lahey

For most startups there are two ways to go in deciding what kind of business entity you should form: A limited liability company, or a Delaware Corporation, according to David Valenti, a partner with Reed & Scardino.
Valenti gave a presentation Tuesday on “What Kind of Entity Should I Form” for Austin Startup Week at the company’s offices, 301 Congress. About 30 people attended.
Among the questions Valenti said startups need to ask themselves are:

  • How much personal liability do I want?
  • Do I want to be able to transfer ownership?
  • How many owners are there going to be?
  • Will there be any foreign owners?
  • How do I intend to raise capital?
  • What kind of management structure do I want?
  • How much corporate maintenance do I want to do with respect to filing documents and meeting regulatory standards?

Of all the most common entities, sole proprietorship, general partnership, limited liability corporation, S Corporation or C Corporation, the LLC and C Corp make the most sense, Valenti said. Both limit the company’s liability, meaning that if there’s a lawsuit, it’s only against the company and not the owner’s personal assets. Both allow foreign partners—which S Corps don’t—which might be important if you hire a foreign national and want to offer equity as part of your compensation.
Also, he said, if a company wants to later convert to a C Corporation, it’s easier to do so from an LLC. The reason for that is that, with an S Corporation, the income of the company “passes through the company” and is reported as the personal income of the partners. With the others, the company’s income is separate and partners take a “reasonable salary.” VCs are often unable to invest in S Corps because some of their investors are non-profits and the profits of a company would “pass through” to the non-profit, violating the non-profit’s status.
If a company intends to bootstrap or raise only friends and family rounds, or even solicit investments from angels, it can do so as an LLC. If a company doesn’t intend to solicit VC funding for several years, setting up an LLC is relatively inexpensive–$300—as compared to the costs of a C Corporation which requires setting up a separate bank account, establishing bylaws and a board and other maintenance costs that could require the services of an attorney and accountant.
But if the company does intend to solicit VC funding, it should set up a Delaware Corporation.
“VCs will tell you they want to invest in a Delaware Corporation because Delaware is very settled on how corporations operate. The whole system set up to litigate corporate matters.”
There is no tax advantage, Valenti said, to setting up a corporation in another state like Nevada. At one time, the “tax friendly” status of the state where the entity was set up would ease a company’s tax burden, but that’s not the case any more. Startup partners, he said, should set up the entity in the state where they live and operate. And they shouldn’t use their home addresses if they have no office. They should setup an account with a company that provides a street address and suite number instead of a P.O. Box.
Reed & Scardino work in several areas of business law but have a special focus on startups and the issues surrounding founding a company. The firm is offering office hours during Startup Week for
companies looking for individual help.

Comments

  1. There’s a lot of other things to consider when selecting the entity to embody your start-up. If you do elect to start an S-Corp or C-Corp, you have to set up payroll which costs money and time figuring out what to pay not only employees but yourself. There’s a pretty good explanation of that here: http://www.northwestregisteredagent.com/IRS-Scorp-election.html. Also, Delaware can be a pretty pricey state in which to form a corporation as compared to others. Plus, if you form a corporation in Delaware, but are located in a different state and have employees, you’ll also need to file in your home state, for which initial fees can start to add up. Just food for thought.

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