Available Corporate Structures for Your Startup

Patrick:     Hi, this is Patrick Henry, the CEO of QuestFusion, with the Real Deal…What Matters. I’m here today with Jeremy Glaser from the Mintz Levin Law Firm.

Jeremy also serves as the co-chair of the firm’s venture capital and emerging companies practice. He works with both venture capitalists as well as with entrepreneurs. He brings a unique set of experiences.

We’ve had Jeremy as a guest on the show before. We love talking with him and getting his insight on legal issues. Jeremy has tons of awards and recognitions. He was most recently named the San Diego Venture Capital Law Lawyer of the Year. Congratulations on that, Jeremy.

Jeremy:     Thank you.

Patrick:     He is a past president and board member for the San Diego Venture Group. He is a member of the American Bar Association. Today we’re going to talk about corporate structures available for startups.

As you’re starting a company, what are the things you need to consider, the pros and cons of various different kinds of corporate structures? Jeremy is an expert on this and many other things.

Can you describe in laymen’s terms the available corporate structures for startups and the things you need to think about in terms of where the company is ultimately going to go, as well as pros and cons of starting in a particular place?

Jeremy:     There are three types of structures. There are four, but there is one that we won’t talk about because we don’t use it often for startups and technology companies. That’s a partnership. We’ll put that one aside. The three structures are sole proprietorship where you don’t have a structure at all.

You’re just starting your own business. We can put that one aside pretty quickly for the simple reason that you don’t want to do business as a sole proprietor if you’re an entrepreneur trying to build a company to ultimately raise money from investors.

No one is going to want to invest in a business that has potentially unlimited liability. Even if you’re staring a bicycle shop, I’d tell you that you don’t want a sole proprietorship. You want to be some sort of an entity.

Patrick:     When does it make sense to be a sole proprietor and just get a DBA, Doing Business As?

Jeremy:     As an attorney, I would say never. It’s so inexpensive these days to form an entity and get the protection of either a corporation or a limited liability company. I can’t picture any situation in today’s world with the litigious society that we live in that you would want to expose yourself as a sole proprietor.

I think we get rid of those two outliers and focus in on a corporation or a limited liability company. That’s where everyone goes to form their companies. Let’s talk briefly about limited liability companies because they’re newer than corporations.

Patrick:     This is an LLC.

Jeremy:     Yes, it’s an LLC. They are relatively new but they’re really fabulous structures. The primary reason that they’re fabulous is that they give you the benefit of limited liability combined with what we call flow-through taxation. What does that mean? You don’t have to pay taxes on the earnings of that entity.

Instead, if a company has earnings or losses, those earnings and losses flow through the entity. The entity is ignored and you as the entrepreneur, or your investors, get to take those losses or profits onto your own personal income taxes. That can be very beneficial because you’re avoiding what we call the double taxation, which can happen in the corporate structure. That’s a great advantage with an LLC.

There is another type of corporation that could also give you that pass through treatment, which is called an S Corp. We can talk about that a little more in a moment. The beauty of an LLC is that it’s incredibly flexible. You can structure an LLC any way you want. You can create a board of directors or not. You can have what are called preferential returns for different owners or you can have everyone at the same ownership level.

You can have officers or not have officers. You can draft them for any sort of structure or relationship that you want among your investors. I’m a big fan of LLCs for most companies. I’ve become a bigger fan of them in the context of the technology world and startup companies recently. It’s now very easy to convert. You talked about changing entities.

It’s become very easy now to convert from a Delaware Limited Company into a corporation. Why would you do that? The reason is that venture capitalists prefer to invest in the corporate structure. They’ve become accustomed to preferred stock. They understand what a Delaware Corporation is and the law around that.

A lot of people start at LLC and do that conversion now. The reason is that the LLC gives you the benefit of that flow-through of losses. As we all know, startup companies usually have losses in the early years. Rather than having those losses locked up in the corporation where they may or may not be useful, you get to have those losses go to the benefit of your investors, which can be viewed as a real benefit for early-stage investors.

You operate as an LLC until you bring in the institutional financing, at which point with a very simple filing, you then convert to a corporation. I’m seeing a lot more of this. In the last year, I’ve been advising companies to start as an LLC and do that conversion when it comes time for the institutional investment.

Let’s circle back to the more traditional corporation. Corporations are the preferred form for any company that is going to take institutional money. Again, it provides limited liability. It has very clear rules, regulations and court opinions about boards, fiduciary duties, officers and structure.

They are well established and simple to put in place. Corporations are fabulous structures and are required if you’re going to do down the venture capital route.

Patrick:     You have S Corps and C Corps. Are those the only two varieties or are there other things out there?

Jeremy:     There are other varieties. The two that matter most for people doing a for-profit business are the C Corp and the S Corp. That’s basically a tax election. One of the things people get confused about is that they think they are different corporations. They’re not. It’s a tax election. You elect to be an S Corp.

If you don’t make that election, you’re going to be taxed as a C Corp. A C Corp is one where the earnings stay in the business. If you have profits in the company, you’re going to pay taxes at the corporate level. If you try to distribute the money out, you’re creating this double taxation issue. That is probably okay for a lot of technology companies.

As you know, there are not a lot of startup companies that are paying dividends. They’re building up the value in the business. The goal is to go public or to sell the business. A C Corp is a perfectly good structure for that. It’s the preferred structure, ultimately, for that entity.

What we used to do is start companies as S Corps. Again, the benefit of the losses would flow through to the early investors. Once the institutional investor came in, the S Corp would be invalidated by law. You can’t have an entity stockholder in an S Corp. It would automatically convert to a C Corp at that point.

The reality is that S Corps have a lot of limitations and restrictions on the nature of the investors, and the different classes and rights of ownership that you can put in place. I really don’t use S Corps anymore. I almost always use LLCs.

An important point for people to be aware of, particularly here in California, are the advantages of being in Delaware. A lot of times, I have entrepreneurs show up at my door and they’ve formed a California Corporation or California LLC using an unnamed company. They can do it online. It’s very inexpensive. I think that’s a mistake.

When companies walk in the door, I use the example of a bakery. In that case, a California corporation or a California LLC would be fine. But if you’re going to be taking outside money, you want to have the clarity of the Delaware law of the rights and responsibilities of you, as a director, a majority stockholder and your officers. I urge people not to form entities in California but to go to Delaware.

Delaware is a really high-service state. What does that mean? When you’re doing financing, as you know, time is of the essence. If you want to close your financing, you want to know that you can send in your amendment of your certificate that’s creating your preferred stock and get it back instantly, so that you can close your financing. Delaware is set up to do that. It’s very high service. California is not.

You could sometimes have very significant delays that could delay the way you’re closing, which is never a good idea. The bottom line when you’re forming a company is to start as a Delaware Limited Liability Company, assuming that you see the value of getting the losses onto your investor’s individual financials and taxes, knowing that you’ll convert into a corporation when you get institutional investors.

Patrick:     This was great. It was very informational, as always. Thank you so much, Jeremy. I really appreciate your insight on this.

Jeremy:     It was my pleasure. Thank you, Patrick.

Patrick:     This is Patrick Henry, the CEO of QuestFusion, with the Real Deal…What Matters.