A very common question that gets asked is “what type of company should I form for my startup?” What most people mean by this is, “what type of legal entity should I form my startup as?” In other words, out of the several options available, what’s the best? Let me break down those options briefly, and give my opinion on the best option for a startup and why.
This is when you start doing business without forming or doing anything. Technically, this isn’t exactly a legal entity or anything that you would be ‘forming’, but I’m listing it because by default, if you begin doing business as one person, by default you’ve created a sole proprietorship. We’ll quickly move on from here because a sole proprietorship gives you no limited liability protection. There’s no shield between your personal assets and someone coming after you for something you did wrong while operating your business.
If you and at least one other person start doing business, you’ve technically formed a general partnership as far as most states’ laws are concerned. This is just as bad as a sole proprietorship, except now whichever one of you has the most money will be the one they’ll take it from if you lose a lawsuit. You do have the option of creating a limited partnership (usually reserved for professional offices like dentists and doctors, or investment companies for reasons not worth discussing here) or a limited liability partnership (LLP). In an LLP, typically each partner is liable only for whatever damage is assessed against them without affecting the entire partnership. Which means, there’s still a liability issue.
Limited Liability Company
In an LLC (one of the most common entities) you get a lot more freedom than in a corporation, but without the hangups of an LLP. You also get the displacement of liability that you’re missing with a sole proprietorship or general partnership. Generally less corporate governance paperwork (meeting minutes, annual meetings, votes and answering to shareholders) and simpler operation. This must be the best one, right? Not exactly.
With an LLC, you have more difficulty (compared to a corporation) bringing members on, or getting rid of them - including investors. Creating a different class of ownership requires amending the operating agreement, which requires review of the same thing by lawyers of all the various members. In fact, doing anything in an LLC that involves bringing someone in requires review and possible revision of the operating agreement until it’s to the new member’s liking - which is not something an investor wants to deal with. Especially when they might be investing in multiple companies per month (or even, per week for the big firms!)
So that leaves...
The O.G. of entities. Dating back centuries to England. Remember the Dutch East India Trading Company we learned about in school? One of the first known corporations - people pool their money in an investment in some new organization that operates a business. Since then, a lot has changed and a lot has not. Corporations still involve one or more people providing some type of compensation (money or labor) in exchange for ownership in some separate legal existence that will operate a business and hopefully generate a profit that will be shared among the people who hold shares of ownership. So what makes this different?
This is the typical and chosen default for startups for several reasons:
- It’s the standard. It’s been the standard for so long that it’s become...the standard. Kind of like how some celebrities are famous for being famous.
- Because it’s the standard, it has become streamlined when doing routine things. Creating a new class of stock involves standardized paperwork and even classes of stock are fairly standardized. Creating options is standardized and routine. Giving out options or shares to employees is standard process with its own set of paperwork that every lawyer or startup veteran recognizes.
- Following the rules is a little easier because they’re well known. Corporations have existed for so long and the rules governing them are so set in stone and rarely change, that it’s pretty easy to know the right thing to do in just about any situation. There’s almost no guesswork involved in anything a corporation does or any situation it finds itself in.
- For the above reasons, investors strongly prefer the corporation model of entities and will almost always insist that a company is organized as a corporation before it will actually invest.
One of the greatest advantages that the widespread use of the corporation entity has on startups is that it has made the entire process of starting and operating a corporation very straightforward and easy for even novices to learn and understand. This can sometimes feel constricting for companies that would prefer the ease of operation of an LLC, but it’s also freeing because it cuts down time, effort, and legal fees for almost every transaction a startup will engage in.
If you’d like to learn more about this, please download my free ebook “The Startup Law Guide” where I explain more about this and other topics new startups should know.
If you’d like to talk, feel free to reach out directly and let’s chat!