How to Choose the Right Business Entity for Your Startup
- Kevin Gibson
- May 31, 2023
Startup founders and entrepreneurs face many decisions and challenges, ranging from product development to financing to staffing and more. Choosing the right business entity is one of the most important early decisions that founders can make. The type of entity has long-lasting operational, legal, and tax implications for the company and its owners. Founders must weigh the advantages and disadvantages of various types of entities and how they apply to your business.
What are the initial considerations for choice of entity?
Initially, startup founders should consider the number of owners of the business and how the earnings of the business will be returned. While having two or more founders may help scale your startup, it also opens up room for uncertainty around ownership which can lead to crippling disputes, so it’s important to agree on equity ownership and vesting upfront.
Founders should also proactively consider how to protect their personal assets from liabilities arising from the business, how to handle taxation, how to pursue tax benefits that can be impactful to business owners, and the operating costs and expenses associated with the business entity.
What are some long-term implications to consider before choosing your entity?
Startup founders should also keep their longer-term business goals in mind before choosing a business entity. For example, as you staff up and grow your team, do you want to offer equity compensation to employees? Do you hope to raise institutional investment in the future?
Investors will be looking for proper formation documentation, properly classified workers, and ensuring that the intellectual property is all properly owned by the entity. Investors will want to see that founders have properly issued equity and there are no questions or disputes about who holds equity in the entity.
What are the most common types of business entities?
Sole proprietorships, partnerships, limited liability companies (LLCs), and C corporations (C-Corps) are the most common entity types. Here’s a quick breakdown:
- Sole proprietorship: In a sole proprietorship, one individual runs the business from their personal accounts and is personally liable/responsible for the business.
- Partnership: In a partnership, the founder shares responsibility for the business’s debts with a partner and the entity’s tax return is separate from personal tax returns.
- LLC: A limited liability company or LLC can be formed by one or more owners, called members, and is often managed by one or more managers. While LLCs may provide considerable benefits including “pass-through” taxation to avoid the potential of double taxation in a C Corporation and greater structural flexibility, there can also be potential for greater complexity, both from a tax perspective as well as in preparing and maintaining an operating agreement.
- Corporation: A corporation is established by filing articles of incorporation and is comprised of shareholders, directors, and officers. Unlike an LLC, corporations are taxed at the entity level. Income may be taxed again if and when it is distributed to shareholders.
- S-Corp: Note that for several entity types, you can also elect to make an s-corp election, which further changes how the entity is taxed. This decision involves a variety of tax considerations and should only be made after consultation with tax advisors.
Advantages of a C-Corporation
Conventional wisdom often suggests starting a business as an LLC, and for many, an LLC might work well. But there are several advantages of c-corporations that startup founders should be aware of from the start.
Many startup companies grant equity compensation to employees. In a c-corporation, it is generally less complicated to issue standard equity options than trying to grant equity in an LLC or other type of entity.
For companies that intend to raise institutional funding, starting with a c-corporation might be the best choice because this is a preferred type of entity for those types of investors. This is in large part because the setup and taxation for c-corporations is much more straightforward and appealing for institutional investors to manage.
Additionally, c-corporations can more easily qualify for tax incentives and exemptions like Qualified Small Business Stock or QSBS. If a number of qualifications are met, this allows eligible shareholders and investors to exempt up to 100% of future capital gains tax on the sale of their QSBS.
As businesses evolve over time, it might make sense to convert your entity or its tax classification down the road. For example, an LLC may need to convert to a c-corporation in connection with an institutional investor led financing. While this is possible, the process can be messy depending on the state of the company, the ownership structure, and whether the business has raised funding or granted equity to employees. Founders can save time and money by proactively considering the circumstances of their particular business and short- and long-term implications before choosing their business entity.
The specifics of your business should inform your choice of entity
There are several online formation and incorporation services available today that help founders form businesses. Before using one of these services, it’s important to be cognizant of any complicating factors for your business and the long-term implications of your choice of entity.
While there’s no one size fits all approach when choosing your business entity, an experienced startup attorney who specializes in entity formation, early-stage financings, and corporate law can help you understand the nuances of your business, navigate the entity options, guide you through the process, make your business more attractive to investors, and achieve your long-term business goals.
Kevin Gibson is a corporate partner whose practice is focused on the representation of emerging growth companies, as well as leading angel and venture capital funds in their investments in public and private companies. Reach Kevin at [email protected].