By Celina Kirchner, associate at Michelman & Robinson LLP
One of the first actions you will take with your startup is to organize your company a separate legal entity to protect yourself from personal liability for the company’s debts. In the tech startup context, you’ll typically choose between a Corporation and a Limited Liability Company (“LLC”).
Below are the five major categories you should consider when making this decision:
1. Taxes.
Corporations pay taxes on the money they earn, and LLCs don’t. This doesn’t mean that LLCs go tax-free. When an LLC allocates income to owners (i.e. splitting profits), those allocations are taxed as personal income (for regular people) and corporate income (for corporations), but not as income for the LLC itself. This can also vary as you grow and as some owners pull back from managing the LLC. Owners of corporations also pay taxes when they are paid dividends or profit from sale of the stock, which is why it is common to say that corporations are “double-taxed.” In light of the many nuances of tax law, it is always best to speak directly with an accountant before determining which method of organization provides the best tax benefits for the company.
Verdict: In general, LLCs provide more tax benefits, but this is not always the case — best to talk to an accountant before making a decision!
2. Ownership.
Ownership of a corporation is measured in stock. Stocks are issued at the time the company is formed, and more can be issued over time. You can control the power of your company’s stock by issuing different classes. Typically, investors will be interested in “preferred” stock, which comes with special (aka “preferred”) rights, such as receiving a certain payout before anyone who holds “common” stock.
The ownership structure of an LLC is a blank slate. While the standard is that ownership is determined based on each owner’s contribution to the LLC, the Articles of Organization or the company’s Operating Agreement can change this, so the amount any owner invests does not necessarily determine the member’s share in profits (or losses) of the company.
Verdict: It’s a tie! The LLC can have any ownership structure, but by issuing different classes of stock, corporations have almost as much flexibility, just with more paperwork).
3. Management.
Corporate management is dominated by required formalities—shareholder meetings, a board of directors, resolutions, certificates, etc. Typically, shareholders vote to elect directors (members of the Board of Directors). Then the Directors elect Officers who actually manage the company. In small companies, shareholders may elect themselves as directors and officers, which allows them to run the company themselves. As the company grows, it is more likely that at least some of the shareholders will not be involved in the management of the company. Corporate formalities are required no matter what the size of the company, and the meetings, votes, and paperwork can be tedious. If the formalities are skipped, the owners of the company could become personally liable for the debts of the company, or even be personally named in a lawsuit against the company.
LLCs do not have these required formalities unless they want them. You could use the standard Articles of Organization provided by the Secretary of State,[1] which subject the company to the standard operating procedures in the Corporation Code. The standard gives all members (aka owners) of the LLC the power to manage the company and requires a unanimous vote on all major business decisions. However, a lawyer can create Articles of Organization or Operating Agreements that give you more flexibility in how you run your specific company.
Verdict: LLC. With an LLC, you can skip the board meetings and paperwork. But remember, however, there are management standards in place unless you have a lawyer create an Operating Agreement specifically designed for your company.
4. Earnings.
Corporations are allowed to keep their earnings or pay them out as dividends. This means that the corporation can hold onto money from year to year beyond its operating expenses—with some effect on the company’s taxes. A corporation can therefore build up cash over time. There are also limitations on how dividends are paid out. Depending on how your corporate accounts are structured, you will only be able to pay dividends from a small pool of money.
LLCs offer flexibility in earnings payouts as well. Automatically, each owner gets an equal share of profit distributions, but with a personalized Articles of Organization or Operating Agreement, the owners can structure payouts based on other factors. That being said, as with a corporation, the LLC has to hold onto enough capital to keep running.
Verdict: LLC. An LLC offers greater control over how earnings are used and distributed, but even LLCs have to be reasonable in how they distribute (i.e. not to the detriment of any creditors).
5. Investment and Acquisition Potential.
Even at the earliest stages of developing a business, you should consider whether it is attractive to potential investors; investors are usually concerned about how owners are compensated and how much control they have over the business.
Historically, many investors were more comfortable with a corporate entity, largely because they are familiar (LLCs were first created in 1970, so they’re still pretty new). This is particularly true with venture capitalists or investment funds. However, as already mentioned above, the LLC gives owners the power to create any payout structure the investors may want. Down the line, a potential buyer may prefer the predictable structure of a corporation. Plus, there is the possibility that terms of the LLC Operating Agreement will be challenged during due diligence (the time a potential buyer spends investigating your company prior to purchase). Investors/buyers may even ask that the company be restructured. While this isn’t an impossible task, it can be an expensive hassle and force you to wait longer for the sale to be completed.
Verdict: Corporation. Larger institutional investors often prefer the predictability of a corporate structure and the protections of those pesky operation formalities. You should research the investors you may want to work with in the future to see if they have a preference.
If you would like to make your company a legal entity separate from you or the other co-founders of your startup, you need to choose how you will organize. Typically, that means you’ll be a corporation or a limited liability company (“LLC”). Corporations come with a lot of formalities and tax details that LLCs generally avoid. If you’re running the company yourself, that flexibility could save you time and lower the likelihood that you’ll forget one of those formal steps! However, investors (especially institutions and VCs) tend to prefer the predictability and control of a corporation. Also, as you grow, your LLC will be treated more and more like a corporation anyway.
Organizing your company is a big decision. Get familiar with the process, and make sure to have the right professionals on your team. Doing things the right way from the start will save you money and time down the line.
[1] http://www.sos.ca.gov/business-programs/business-entities/forms#llc
Celina Kirchner is an associate in Michelman & Robinson LLP’s Los Angeles office, who counsels clients primarily in the advertising and digital media, Internet, software and technology, and insurance industries. She can be reached at 310.564.2670 or by email at ckirchner@mrllp.com. M&R is a national law firm with offices in California and New York. For more, please visit www.mrllp.com.
