The Importance of Legal Entity Structure for Startups
Two keys to success in almost any entrepreneurial venture are preparedness and adaptability. When you are bold enough to start a company based on your own unique vision, there are many challenges and issues to consider. But what should not get lost in the ether is choosing the proper type of business entity for your company. Your legal entity structure is both the foundation and the framework that will prepare you to achieve your business aspirations in the future.
As circumstances may change over time, in either your business situation or the prevailing laws, you should be nimble enough to adapt. Case in point, as outlined later in this article, there are some brand-new changes to the Connecticut Limited Liability Company Act that are worth considering if you have established, or are considering establishing, an LLC.
TYPES OF BUSINESS ENTITIES
The simplest and, by far, the most common form of U.S. business entity is the sole proprietorship. Apart from actually opening for business and filing a certificate for the trade name you will operate under, there are no other formal or legal requirements—so there are no associated costs. It is also an advantageous form of ownership from a tax perspective as all income and expenses flow through to your personal income tax return. So, business losses can be used to offset income from unrelated sources. The downside is that the business owner is personally liable for any debts, judgments or other liabilities of the business. In some cases, however, a personal umbrella liability policy may provide some protection.
If two or more individuals will be involved in your business, either as owners/operators or passive investors, a partnership may provide an adequate business structure to meet your needs. This can be a general partnership, in which all partners share in the management responsibility and business liabilities, or a limited partnership with a combination of general partners and limited partners, the latter of which bear no responsibility or risk exposure beyond the level of their personal investment. Exposure to liability rests solely with the general partners in a limited partnership. To lend some formality to the business arrangement and to avoid misunderstandings over roles and accountability, a partnership agreement is usually a good idea. As compared with a sole proprietorship, the accounting for a partnership is a bit more complex. There may be legal expenses involved if you decide to create a partnership agreement, but both entity forms enjoy the benefits of a relatively simple business structure to own and operate along with pass-through tax treatment.
An independent legal and tax structure that is separate from its owners, the corporation is widely considered the best entity structure for business owners who anticipate a significant growth trajectory and seek personal protection from business liabilities and debts. There are a number of state filings and ongoing regulatory and administrative requirements that can be expensive and time consuming, but on the plus side, corporations are perhaps best suited to attract outside investors and shareholders. On the downside, corporations are subject to so-called double taxation in that the business itself is a taxable entity, and the profits, when distributed to owners in the form of dividends, are also taxable to the owners personally. Of course, with the assistance of an able accountant, you may be able to reduce tax exposure by deducting qualified business expenses and by allocating profits to the owners in the form of reasonable compensation.
The subchapter S, or S corporation, is a corporation structure sometimes chosen by smaller companies principally to protect the organization from double taxation. Some of the disadvantages include a limit in the permissible number of shareholders (not more than 75), the requirement that all shareholders be U.S. citizens, and the inability to offer equity interests other than common stock.
Another subset type of corporation that is widely popular in some circles today is the benefit corporation. This entity structure codifies a corporate commitment to act morally, ethically and responsibly with regard to society and the environment. Currently, 33 U.S. states and the District of Columbia have passed laws permitting the formation of benefits corporations, and six other U.S. states are reportedly “working on it.”
Limited Liability Company (LLC)
Considered by some to be the best of both worlds, the limited liability company shares key advantages of both corporations and partnerships. If you form an LLC, you can take advantage of the liability protection of a corporation along with the pass-through tax treatment of a partnership. LLCs also share some of the disadvantages of corporations and partnerships. There is some initial red tape—such as applying for tax ID and employer ID numbers. And just as corporations are required to file a certificate of incorporation and create a set of related bylaws, LLCs must file a certificate of organization and, if there is more than one member, create an operating agreement. After formation, however, LLCs are spared some of the ongoing formalities of corporations. For instance, you will not be required to hold annual meetings and maintain official minutes. One of the disadvantages you’d face is that, as with partnerships, LLCs cannot go public and therefore cannot issue publicly traded stock, making it more challenging to raise capital.
As we have clearly delineated under each of the legal entity structures outlined here, the two principal deciding factors in selecting a form of legal entity are taxes and personal liability. The ability to attract investors and raise capital has been shown as another key issue to consider. Finally, but not insignificantly, there is the cost of establishing and maintaining the chosen business structure—primarily legal, accounting and administrative expenses and ongoing record-keeping requirements.
To delve into the complexities of this topic for startups, we’ve tapped a couple of legal experts who have extensive hands-on experience working with a variety of companies to help them consider all the implications of these decisions.
First, we spoke with Matthew Monteith, an attorney with the law firm Shipman & Goodwin LLP. The following questions and responses outline some of the advice he offers his clients as they begin to think about choosing a legal entity structure.
CI: Should choosing a legal entity structure be among the first things a startup does?
MM: The short answer is that it depends on your circumstances—whether your business is still in the idea stage or further along, whether you are working alone or with other owners, and the specific nature of your business and its products or services. It makes sense to wait until your business plan is more definitive. However, before you get too far afield, you must decide on the most suitable business structure. It’s not a matter of whether to establish a formal legal entity; it’s a matter of when.
CI: What is the most important factor to consider in the decision whether to incorporate?
MM: The number-one reason to establish a corporation or an LLC is to limit liability. If you plan to sell a product or service that has the potential to cause physical harm or financial loss, you will want to form a legal entity that will provide some protection. If you were to form a sole proprietorship or a general partnership, all of your business and personal assets would be fair game for potential litigants, whereas with a corporation or an LLC, you effectively segregate the assets of the legal entity from your personal assets. It is important to note, however, that merely establishing a corporation or LLC is not enough—your personal assets are only protected to the extent that you follow the legal entity rules. For instance, if you continually access business assets for your personal use, you may invalidate the justification to shield your personal assets. This is what is called “piercing the corporate veil.”
CI: What other issues come into play in the legal entity choice?
Certainly the tax implications are an important factor—beyond the issue of whether your business will be a pass-through or subject to double taxation, there are other tax benefits and rules to consider. Other than that, if you have intellectual property, if you are ready to begin selling your product, if you have multiple founders, if you plan to seek outside investment, if you will be entering into a contract on behalf of your company . . . in all of these situations, you will be well served by the formality and established parameters of a defined legal entity structure.
CI: If raising capital will be vital to a startup, how will this impact the legal entity decision?
MM: From a practical standpoint, your target investors will often drive your decision in terms of legal entity form. Most institutional investors tend to prefer to invest in C corporations, although many are certainly willing to invest in LLCs. Of course, if an initial public offering (IPO) is likely in your future, you’d have to convert your LLC to a C corporation before going public. The other potential downside of the LLC is that some individual and angel investors are not as comfortable with the LLC terminology of members and managers as opposed to the more familiar shareholder role.
ADAPTING TO CHANGE
Even after you have chosen a business structure, that doesn’t mean that nothing will ever change. The factors that make one type of business entity best suited to your company may be impacted by changes in the law. In fact, there have been some major changes to the Connecticut Limited Liability Company Act that just became effective on July 1, 2017.
To explore the significance and impact of these changes, we spoke with Gregg Lallier, an attorney with the law firm Updike Kelly & Spellacy PC.
CI: It has been stated that the new LLC act will create a more “business-friendly” legal environment for LLCs. How so?
GL: One of the chief disadvantages of the prior LLC act in Connecticut was its lack of uniformity as compared with the laws of other states. The new act—the Connecticut Uniform Limited Liability Company Act—is patterned after the Uniform Act that is currently in place in 17 other states in the United States. This is important because we can now look to the legal precedents already established in those other states for guidance as we endeavor to apply the new act to LLCs operating in Connecticut.
CI: Can you point to some of the new law’s more noteworthy aspects of which existing LLCs should be aware?
GL: There are some changes in the new act that redefine the fiduciary duties of members and managers and their related duty of loyalty. Essentially, the new act treats members who are not managers of the LLC more akin to shareholders whose only risk exposure is the extent of their investment in the business. Many would consider this a positive change. There are also certain other stipulations in the new act with regard to the voting requirements to amend the certificate of organization or operating agreement and the votes required to admit new members to the LLC. In these and other matters related to the new act, by and large the law will continue to defer to the existing operating agreement as the final arbiter of operational protocol. It is worth noting, however, that in cases where the operating agreement is silent on a specific issue, the default provisions of the new act will prevail. And in other cases, the operating agreement is prohibited from contradicting the new act.
CI: Should existing LLCs make changes to their operating agreements based on the new act?
GL: You don’t necessarily have to redo your operating agreement. However, due to some of the nuances referenced in the previous question, prudence would dictate that you should have an attorney review your existing LLC operating agreement to determine whether any modifications are called for.
CI: If a new company is considering various legal entity structures, is there anything about the new law that might make choosing an LLC more compelling?
GL: There is nothing specific in the new act that makes an LLC any more or less compelling. Choosing a legal entity structure is really more of an economic than a legal issue. An LLC will always be attractive if you want to take advantage of having income pass through to your personal tax return and have the ability to offset income and losses. But the predominant deciding factor comes down to whether your company will need outside investors. If it will, you may find that investors have a specific preference of entity structure and perhaps a preferred state of incorporation—for example, Delaware.
THE BOTTOM LINE
Determining the most advantageous legal entity structure for your startup is an important decision with far-reaching implications. Therefore, it’s one of the pivotal times when you really should seek out professional tax and legal advice. Although you undoubtedly have a firm grasp on the near-term needs of your business and the future state you are striving for, there is great peace of mind in having experts to guide you through the myriad opportunities, risks and “what-if” scenarios that simply may not occur to you.
Gregg J. Lallier is an attorney and shareholder of Updike Kelly & Spellacy PC. His practice primarily focuses within the high-tech and venture capital industries. Gregg has represented both mature and emerging growth companies in a variety of high-tech enterprises, including software, information technology, e-commerce, clean technology and healthcare services and equipment. He also regularly represents angel, venture capital and other institutional investors.
Matthew Monteith, a former CI employee and an associate with Shipman & Goodwin LLP, practices primarily in the areas of business and finance. He represents commercial banks, venture capital investors, private equity funds and other senior and junior lending institutions, as well as emerging growth companies and other corporate borrowers, in connection with a variety of commercial transactions including term and revolving credit facilities, mezzanine financings, acquisitions and dispositions, preferred equity investments, entity formation, and general corporate and contracting matters.