STARTUP 2009 LEGAL SERIES Topic #2 Forming an Entity
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Forming an Entity
Reasons for forming an entity Corporation Partnership LLC Selecting a form of entity Relevant sample documents
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Reasons for forming an entity
Limited liability—an entity can shield an entrepreneur’s personal assets from liabilities of the business Tax benefits Attracting investors Hiring and providing incentives to employees
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Corporation
Corporation is a distinct legal entity that has:
Stockholders—owners of the business Board of Directors—makes important corporate decisions Officers—conducts day to day management Profits and losses of an S corporation are passed through to the stockholders—meaning there is no “double tax.” However, S corps are subject to limitations that make it difficult to raise venture capital.
Taxed as a separate entity, unless it elects “S corp” status
Stockholders generally enjoy limited liability—creditors cannot pursue stockholders for the debts of the corporation. Companies often organize in Delaware because of advanced corporate law and sophisticated business courts.
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Partnership
Types
General Partnership—general partners have unlimited liability. Limited Partnership—limited partners have limited liability; general partners have unlimited liability Limited Liability Partnership—often used for professional service firms (law firms, doctors etc.) Partnership agreement is recommended to address allocation of profits and losses, dissolution, dispute resolution etc. The entity is not taxed—it is a “flow through” entity. Flexibility in allocating profits and losses among partners.
Administration
Tax Treatment
Raising Capital
Flow through tax status makes it very difficult to attract capital from venture capital funds.
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Limited Liability Company
Attributes
LLCs have become popular because they have benefits of limited liability and flow through tax treatment. Have “members” instead of stockholders. Operating Agreement is agreement among members that addresses the relative financial rights and obligations and governance matters. Terms of Operating Agreements vary widely—members have great freedom in establishing rights. Flow through tax status makes it difficult to attract capital from venture capital funds. Relatively easy to convert LLC to corporation immediately prior to a financing.
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Operating Agreement
Raising Capital
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Selecting a form of entity
Deciding on the proper entity depends on who will own it and how the investors’ capital will be returned Owners
Venture backed companies are almost always C corporations because (i) venture capital funds generally cannot invest in flow through vehicles (i.e., S corps, partnerships or LLCs), (ii) it is easier to structure equity incentives in a C corp, (iii) the shares may be widely held or the entity may go public and (iv) corporations have more established corporate governance standards. If the business will be paying dividends, a flow through entity may be preferable because there is no double tax. If the business will be incurring losses, a flow through entity may be preferable because the investors can deduct start-up costs against taxable income.
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Return on capital
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Relevant Sample Documents for Delaware Corporation
Sample Action of Sole Incorporator Sample Certificate of Incorporation Sample Bylaws Sample Initial Board Resolutions
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