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Lawyers, accountants, and other professionals are indispensable when it comes to starting a high-growth company, scaling it and selling it. Smart entrepreneurs know to surround themselves with people who offer valuable advice and experience that can strengthen their company, and that the first step to making their hard work payoff involves finding a great lawyer.
The first step in starting a business is choosing a business name. The first step in choosing a name for your company is to determine whether the proposed name is available. If the name is not being used by another entity, your attorney will conduct a trademark search to confirm that the name is not registered as a trademark or service mark. If the name is available and is not registered as a mark, counsel should determine, among other things, (1) whether the name is distinguishable from other business names; and (2) whether the name is likely to cause consumer confusion with, or infringe upon, another’s trademark or service mark.
Sole proprietors do not enjoy the benefit of the legal distinction between the individual and the business and are exposed to all of the liabilities running a business entails. Therefore, if you do not operate your business as a separate legal entity, you are personally liable for all of the debts and other obligations of the business.
The type of entity you form can play a large role in determining the future success of your business, as well as have an impact on your exit strategy. Therefore, one of the key decisions you will have to make at the early stages of starting your new company is whether to structure your business as a limited partnership, limited liability company or corporation.
A limited partnership is an association of two or more persons who carry on as co-owners of a business for profit. It consists of at least one limited partner and one general partner. The general partners are personally liable for all of the debts and obligations of the business, but the limited partners typically are not. Limited partners may not participate in the management of the business or they will lose their limited liability status. Private equity and venture capital funds are typically formed as limited partnerships, with the investors as limited partners and the fund manager (or the fund’s investment adviser) as the general partner.
A corporation is a legal entity which grants limited liability to its owners, which means, the owners are generally not personally liable for the debts and obligations of the business. A corporation can either be a C corporation or an S corporation.
A limited liability company is an unincorporated entity that offers limited liability protection to its members. LLCs can be managed by the members, like a general partnership, or by one or more managers, like a limited partnership. Although used less frequently, venture capital funds may also be set up as LLCs. In these cases, VC fund managers become managers of the LLC and investors become members with limited rights.
LLCs offer a number of advantages over S corporations. For example, while S corporations can issue only one class of the company stock, LLCs can offer several different classes with different rights. In addition, S corporations are limited to a maximum of 100 individual shareholders – who must be U.S. residents – whereas an unlimited number of individuals, corporations, and partnerships may participate in an LLC. Therefore, if you will need to create multiple ownership classes, for example, to bring in additional investors who will have no or minimal voting rights, the S corporation is not an option. Similarly, if you plan to attract venture capital or foreign investments, you may have to consider one of the other entity forms for your business.
Most startups and small businesses, including a growing number of VC portfolio companies, are being organized as LLCs. LLCs, and limited partnerships, generally operate with far fewer formalities and enjoy greater flexibility in their business operations and management, than corporations.
Nevertheless, the most frequent reason for choosing one entity-type over another for forming a startup or emerging company, and the ultimate decision as to its State of formation, is motivated by the perceived tax benefits. As such, you or your business attorney should consult a tax specialist or accountant for advice prior to the formation of the entity.
C-corporations are subject to double taxation. The corporation pays Federal income tax on net profits or on capital gains on liquidation; the shareholders pay income tax on any dividends they receive or income paid out to them on liquidation.
Partnerships, LLCs and S corporations are not subject to federal income tax. The profits and losses of these entities flow through directly to the owners (“pass-through” taxation). As a consequence, investors in pass-through entities are liable to be taxed even on income which they do not actually receive (“phantom income”), for example, where company income is required to be reserved for working capital. A good attorney can avoid this tax liability by a careful review or drafting of the operating, partnership or investor agreement to, for example, allow for adjustment to be made to permit the startup investor to receive such income at a later date, tax-free.
The tax consequences of buying and selling LLC and partnership interests is vastly different from buying and selling corporate stock. When you are ready to sell your LLC or partnership interests, the complicated job of determining the basis of these interests necessitate hiring outside counsel and accountants or having a management team well-versed in the tax and financial accounting aspects of LLCs and partnerships. In contrast, the basis for buyers of C corporation stock depends on how much they paid for it, which never changes for as long as they hold the stock.
LLCs and partnerships are much easier to operate and maintain than corporations. However, formation of LLCs and partnerships in New York involve greater up-front, out-of-pocket organizational costs than many other legal entities. This is substantially due to New York’s publishing requirement. In addition, unlike the majority of states, New York requires the members of an LLC to adopt an operating agreement, and the partners of a Limited Partnership, a partnership agreement.
Whereas the corporate formation process for corporations is generally forms-based, such as, certificates for filing with the Department of State, shareholder and director authorizations, corporate minutes, etc., the operating or partnership agreements are always unique documents individually tailored to the situation. For example, the investor who buys LLC interests must give special attention to the allocation of the business income among the members as this could have significant economic consequences for the investor. In contrast, persons buying C corporation stock need not be concerned about how the corporation’s income is allocated among the shareholders. Therefore, heavy reliance on template forms for LLCs and partnerships is ill-advised.
One of the most important component to a successful business is the ability to raise capital. The financing options available to a startup are dependent on several factors, including its choice of business entity.
For many entrepreneurs, the primary source of capital to start their new business and keep it up and running are loans from debt financers. For others, a more expensive source of capital – equity financing – may be the most viable option.
The most common source of equity financing for startups and small businesses is friends and family or “angel” investors. However, it is usually difficult to raise more than $100,000 from friends and family, and due to prohibition on general solicitation and crowdfunding limits imposed by federal and state securities laws, the amount you can raise from unsophisticated investors may also be limited. On the other hand, angel investors often provide the seed money to get a business up and running while entrepreneurs pursue alternative sources of financing, such as venture capital.
Venture capital is money provided by investors to startups and small businesses with high-growth potential, that require large amounts of funding and do not have access to capital markets. Most venture capital funds receive a significant amount of their funding from tax-exempt investors. U.S. tax-exempt investors do not, in general, pay taxes on their share of a fund’s capital gains or ordinary income. They are, however, subject to “unrelated business income tax” (UBIT) on “unrelated business taxable income” (UBTI), that is, income derived from commercial activities unrelated to their tax-exempt purpose. Generating excessive amounts of UBTI can jeopardize a U.S. tax-exempt investor’s tax-exempt status. For this reason, the governing instruments of most venture capital funds prohibit the fund from participating in investments that generate too much UBTI.
A VC fund can incur UBTI by investing in a flow-through entity, such as a LLC or partnership; moreover, for VCs to eventually convert ownership into profits, startups typically need to go public or an initial public offering (IPO) or be bought by another company. Since most startups are organized as flow-through entities to minimize the overall tax burden of their investors, this puts the startup entrepreneur in a dilemma. Do you establish your startup as a C corporation with its disadvantageous double taxation, or do you organize as a LLC and risk being unable to raise venture capital? An experienced attorney can help you analyze the alternatives in the context of the business and the exit strategy.