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First Time Founders Series: No. 1 - Formation

09/09/2020

You’re ready to get serious and make your startup “official.” But how do you start?

In this first installment of our 2020 First Time Founder Series, we’re going to focus on the most common formation options. 

Entity types:

  • C-Corporation 
  • S-Corporation 
  • Public Benefit Corporation 
  • Limited Liability Company

Location:

  • Delaware
  • Your home state

Entity Types. 
Most technology startups are C-corporations. The default rules are well-understood, it is easy to hire employees and reward them with stock, and many venture capitalists prefer investing in C-corporations.

But limited liability companies (LLCs) are gaining on C-corporations. LLCs have few default requirements and allow for flexible structures. They also receive pass-through federal tax treatment (meaning deducting startup losses on your personal taxes) while still limiting personal liability for business obligations. Taking advantage of these benefits requires a sophisticated knowledge of tax rules and custom-drafted documents. This is especially true if you want to issue equity to employees. You may create tax headaches by converting your W-2 employees into K-1 owners. For these reasons, LLCs are much less DIY than C-corporations and require trusted legal and financial advisors along the way.

Like LLCs, s-corporations receive pass-through federal tax treatment and limit personal liability for business obligations. S-corporations are C-corporations that have elected (with the IRS) to be treated as s-corporations. That election has several key strings that make s-corporation treatment unattractive for many technology startups. First, you can only have one class of stock. No “Series A” preferred round for your s-corporation. Second, you cannot have more than 100 stockholders, and those stockholders must be individuals (although certain tax-exempt organizations and trusts are acceptable). Sand Hill Road is taking a pass on your s-corporation.

Finally, public benefit corporations (PBCs) are increasing in popularity. PBCs are different than Certified B Corps. A Certified B Corp. can be any type of entity that is certified by a third-party (B Lab) as meeting certain standards of social and environmental performance, accountability, and transparency. If you fall short, you lose your certification. PBCs are a relatively new type of legal entity designed to produce a public benefit and still provide stockholder returns. Most, but not all, states allow PBCs. PBCs act like C-corporations with added legal responsibilities to fulfill their stated mission. If you fall short on those responsibilities, there are potential legal consequences beyond losing a third-party certification.  

So… which entity should you choose?

If your goal is to be a fast-growing technology company, rewarding your employees with stock options, funding your growth through large venture capital investments, and looking for a late-stage exit or IPO, a C-corporation is the right fit.

If you expect a leaner team with sophisticated players, want greater flexibility in how you allocate returns, and/or anticipate an early-stage exit, take a serious look at either an LLC or s-corporation. You can always start as an LLC and later convert to a C-corporation. Or, if you elect s-corporation status, you can revoke that election. In both cases, talk to your financial advisors to avoid tax errors.

Finally, if you are passionate about your company’s mission, talk to your network and legal advisors about either becoming a Certified B Corp. or forming as a PBC. 

In all cases, if you are going to fund your startup with other people’s money, get feedback from those anticipated investors and/or their networks. Some institutional investors cannot invest in LLCs because pass-through tax treatment is not viable for their tax-exempt partners. Other institutional investors simply dislike LLCs and prefer C-corporations. On the other hand, some angel investors (and large angel investor networks) strongly prefer investing in LLCs. There will be impact investors that focus on PBCs, while other investors may see that as a distraction or even detrimental to their potential returns.

Location.
Okay, so you have selected your entity type, but where should you incorporate? Almost all large technology companies are Delaware corporations. Delaware is the go-to-state because it has well-established business laws that give both flexibility and certainty to businesses. There are also specialized courts in Delaware for business disputes. In short, Delaware is company-friendly with few surprises. 

But forming your company in Delaware does not mean you can ignore your home state. You will also need to qualify as a “foreign corporation” in your home state. You will then be subject to Delaware corporate laws (and taxes) as well as laws (and taxes) applicable to foreign corporations doing business in your home state. 

So if you’re primarily doing business in your home state and/or do not expect to take investments from larger venture capitalists (who will expect you to be a Delaware entity), you should look at forming your startup in your home state. Be careful, some states are more business-friendly than others. Again, ask your potential investors and get input from your advisors.

Next Steps (and what we didn’t cover).
You are now ready to go. You have picked your entity and know where you want to incorporate. Many, but not all, startups are formed with the help of lawyers (like me). You may already know a lawyer, you can get a referral from your network, or you can track one down on a growing number of online resources. There are lawyers at large law firms, regional firms, small firms, and solo practitioners that can help you form your business.

You can also try DIY formation. Any good DIY service will come with lots of caveats about the need to still consult with a lawyer, ideally before you submit the formation paperwork. Forming a company is a legal process. Mistakes are routinely made. It is true that most (but not all) of these mistakes are fixable, but sometimes at considerable cost. 

Finally, we did not cover everything here. We did not discuss the perpetual existence of corporations, and we barely touched on the distribution of returns, tax treatment, and employee ownership. I encourage first time founders to get input from their networks and seek out trusted advisors as you get started. There is a wealth of knowledge out there and different opinions. Get informed and make the best choice for you and your startup.
The next installment of this First Time Founder Series will discuss founder stock.

Originally posted on Galvanize.

ABOUT THE AUTHOR

Rose Standifer

Co-Chair, Business Section