This is one post/chapter in a serialized book called Startup 101. For the introduction and table of contents, please click here.
Should you set up an LLC, C Corp, or S Corp. And in what state should you register? These are some of the questions we’ll consider in our overview of company registration choices for your startup.
Three warning notices. The first is the obligatory IANAL (I Am Not A Lawyer) statement, with “Be sure to seek legal advice” advice tacked on, which ensures that no lawyer will sue me for bad advice. The second is that this is considered a boring subject by most engineers and entrepreneurs. If this is your instinctive reaction, note that the only thing more boring and time- and money-consuming than getting this right at the start is the nasty mess you’ll find if you get it wrong. The third is that this is US-specific. We don’t have the time to explore legal and tax options in other countries. However, if you are currently not based in the US, we look at the pros, cons, and constraints of setting up your company in the US versus where you live.
Turn Boring into Learning
Here is advice from Alex Iskold, an engineer and entrepreneur:
“You have to take care of legal and financial aspects of the startup, so why not turn it into a learning experience? The legal and financial aspects of your company are important and interesting, and there are a lot of new things and ideas that you will encounter that will likely impress you.”
Learning these aspects also saves you legal fees. If you understand the basics and have a clear set of objectives, you end up only having to say to the lawyer, “Check this.” That is way, way cheaper than asking, “What should I do?”
Breaking Down the Decision
When you have more than two options, a decision gets complex. The way to simplify is to reduce dependencies and break them down into a choice of two, with a subsequent set of additional decisions — a decision tree, in other words:
- Step 1: LLC or Inc?
- Step 2: If Inc, then C Corp or S Corp?
- Step 3: Which state?
- Step 4: All of the other pieces of information you’ll need to fill in when registering a company.
LLC or Inc?
When you see CoolSite Inc, it is usually referred to as a Corp (corporation); the “Inc” is short for Incorporated. Otherwise, you’ll see CoolSite LLC, which stands for Limited Liability Corporation. So, an LLC is also a Corp. Confused already? You wouldn’t be the first!
Many lawyers advise startups to go for LLC for two important reasons:
- It is much simpler to administer; less paperwork. This may sound minor, until you find that you’re the one doing the paperwork at the expense of real work (building your product, selling to and serving clients, etc.).
- No double taxation. Profits for an Inc are taxed twice, first for the corporation, and then the dividends are taxed at the individual level. The members of an LLC (the equivalent of shareholders in an Inc) are treated by the IRS as individuals.
An LLC provides the liability protection of an Inc corporation. In plain English, if someone is owed money by your company, he or she would be able to go after the company’s assets, but not the personal assets of the company’s owners.
An LLC incurs one cost that an Inc does not: the annual franchise tax (about $800 annually in California). But that should be minor compared to the advantages noted above.
LLC Is Better for an Asset Sale
If you bootstrap and sell the company quickly, your buyer may want to buy your assets (the website, users, technology, etc.) rather than buy the whole company by buying all the shares. Buying the shares is more complex for the buyer. This really matters if you are selling to a big company. Managers of large companies have to follow rules, and the rules for acquiring companies are very, very lengthy. This can be a real deal-stopper. They may simply say, “Asset sale or no deal.”
Here is why this matters if you have an Inc: double taxation. Say the buyer is willing to spend $1 million. If the Inc sells the assets, that money is regarded as revenue. So, if you had $100,000 in costs, then $900,000 would be taxed at the corporation level (around 35%). Then the after-tax amount would be given to shareholders (you and your partners) as dividends, and you would pay tax on the dividends (currently 15%, but historically the same rate as income tax: i.e. higher). In other words, ouch!
So, setting up an LLC makes sense, right? Not so fast. Venture investors (VC funds and most angels) need an Inc before they can invest.
For Most Investors, You Need to Be an Inc
You can get investors with an LLC, but they will need to become members, which is a bit like what common shareholders are in an Inc. You won’t be able to sell “preferential shares,” and you will need to sell preferential shares if you want to get venture capital. Don’t worry for now what preferential shares are: we’ll cover that in a later chapter.
Okay, still simple. If you plan to bootstrap with only money from friends and family, go for an LLC. If you want venture capital, set up an Inc. But what if:
- You want to bootstrap for a couple of years and then raise money? Then an LLC is probably the right choice. You can convert from LLC to Inc later. It is not as easy as some people will tell you, but it can be done. By that time you will be making money and can afford a lawyer to get it done right.
- You don’t know whether you will be able to raise money. You can set up an Inc very fast, much faster than you can convert from LLC to Inc. So maybe you should defer incorporation until you are close to raising money.
In these gray areas, when you are not totally sure whether you will be bootstrapping or raising venture capital, the choice of Corps (C Corp or S Corp) may help.
C Corp or S Corp?
There are two types of corporations:
- C Corp: This entity pays a corporate tax, and the shareholders pay income tax on the distributed profits/dividends. This is called double taxation.
- S Corp: This entity does not pay a corporate tax. As in an LLC, earnings and losses are passed on to the shareholders, and then they pay personal income tax. The drawbacks (for some people) are the limits on shareholders: no more than 100 of them, they must be individual US citizens or residents, and only one class of stock is allowed.
At first glance, S Corp sounds like the ideal solution: no trade-off required. But remember that only one class of stock is allowed. That means no preferential shares and no venture investors.
So, the choice is really back to Inc versus LLC. Keeping it simple, if you aim to bootstrap with only simple debt or common equity from friends and family, go the LLC route. If you plan to raise venture capital, set up an Inc.
The choices here are:
- The state you live in,
- Another state like Delaware that allows out-of-state shareholders to set up companies. Nevada is an alternative.
Brick and mortar startups (retailers, for example) set up in the state where the owners live and do business. For Web startups that do business nationwide and globally, location is less relevant. What matters is which states make it easier to set up and administer a company, and which states are better if you have to go to court.
Delaware is the most logical choice. If you want to explore this issue further, check out the differences between Delaware and Nevada. But most entrepreneurs are probably saying by now, “Enough already! Let me get back to the real work of building my venture.”
Converting from LLC to Inc
Let’s say you decide to bootstrap with only simple debt or common equity from friends and family. But a couple of years into your venture, you find that you do want VC funding after all, and a VC wants you. You will need to convert from LLC to Inc. Presumably, by then you will be a bit more established and able to hire legal help to get it done right. So the only considerations now are:
- Is it possible to convert from LLC to Inc? Short answer: yes. How hard is it to do? Not very hard.
- What can you do now while setting up and running your LLC to make this process simpler.
How hard really is this conversion? The answer is, it depends, and you should consult a tax professional. Converting from LLC to C Corp can usually be accomplished without triggering any income tax for the owners or the company, but issues may arise.
If the conversion keeps ownership exactly the same — five LLC Members becoming five Inc shareholders with the same ownership percentage — then the conversion will be quite simple. If you intend to do “a little restructuring,” then you’ll need to speak with a tax professional.
But these are issues to think about closer to when it happens. You cannot really plan for it now. We’ll revisit this in the chapter on “Planning Your Exit.”
Company Administration Basics
This list assumes your company is an Inc. An LLC is similar, but a bit simpler and with different terminology.
You can do this online for a few hundred dollars. You would be wise to have a lawyer check that nothing specific to your venture requires a change. But this is almost always an off-the-shelf job, not a custom project.
Find online firms that do this by Googling “Incorporate your business.” Do a dry run, print out all the forms, and make sure you know how you will be filling in the details. You will be asked for such information as the number of shareholders, their names and addresses, and who will take jobs such as Company Secretary (you or your buddy: who is better at performing boring admin tasks?).
You will get standard forms for:
- Corporate bylaws and maintaining board minutes,
- Shareholder agreement.
Give these to your lawyer for a quick once-over. If you don’t have a lawyer buddy who will give you a couple of hours of free time, find a lawyer who specializes in tech startups. Most will do a bit of basic work for deferred compensation.
More important are the:
- Employment agreements,
- Stock options plan.
Again, the forms are standard; get a lawyer to quickly review. But read Building Your Team Pre-Financing to make sure you’re clear on what you want to do first.
Get an Accountant and Bookkeeper
The legal stuff is mostly a one-time deal, but finances are ongoing and require continual attention. Being attentive to these details will make money-raising and exiting a lot easier. And if you never raise money or sell the business, it will make tax preparation easier.
You’ll need two types of people:
- Accountant. You’ll need this expensive expert once a year (like a lawyer) for an audit and tax preparation.
- Bookkeeper. This lower-cost clerical person makes sure your basic income and expenses are recorded properly every month, making the accountant’s job simple (and inexpensive).
What If I Am Not in the US?
Then you have two choices:
- Set up your company locally. The process is different, and you will need a manual on how to do this. Many concepts are similar, but the forms, terms, and details are different.
- Set up your company in the US, probably in Delaware.
So, how do you choose? Look at these parameters:
- Are you based in a big country that has plenty of local customers, VCs, and angels? If so, you may want to register your company locally.
- Are you based in a small country that has very few prospective customers, VCs or angels? Cross-border deals scare off most investors, certainly American ones. Check that the laws of your country allow you to own a foreign company. US companies can have foreign shareholders, so no problem on that count.
Don’t even think about complex structures, with the parent company in one location and subsidiaries in other locations, unless you already have a lot of capital and can get proper advice.
Photo credit: Gregory James Walsh.