Friday, October 13th may seem like the beginning of a horror story, but it was anything but one at RevIthaca’s Mindset for an Investible Company workshop. Entity formation, how to deal with real boards of directors, the critical aspects of founder relationships, and the basics of raising dilute financing from VCs and other investors were the main topics of the three-hour workshop.
For the founders of any company, the question of entity formation is very important as the decision can set the tone for not only the founders and employees but also those who invest in the company.
There are several entities that an entrepreneur can use to set up a company. Below are the structures Rev Ithaca’s workshop presented as well as the opportunities and challenges each structure offers. Bear in mind that it is crucial to consult with a lawyer and/or accountant before choosing an entity.
This is the most applicable form of entity to startups. This is because raising capital as a corporation is easier than other entity forms. In general, corporations must file a Delaware certificate of corporation. Once an entity exists, it must be owned by issuing stock to the shareholders. During the initial stages of the startup, the founders will probably be the shareholders. The shareholders then elect the Board of directors who then hire the officers (CEO, President, VP, CFO). The officers oversee the day to day running of the company. Initially, the board will consist of the founders, and the CEO position will likely also be filled by one of the founders. However, this will likely change as the company grows.
Note that there are two forms of Corporations – C Corporation and S Corporation. The S-letter designation is simply a tax filing with the IRS and the state filing authority that states the corporation wants to be taxed as a pass-through entity, like a partnership. In a small business, the S-Corp is acceptable. The owners in this case would be looking to get the pass-through losses for their own personal tax returns.
It is important to keep in mind that there are qualifications to being an S-Corp: a shareholder limit of 75 and all shareholders have to be a “warm-body” (except for shareholder non-profits). Once these requirements are surpassed, however, for example by having too many shareholders or having a venture capital firm as part of the board, the entity is automatically disqualified from the “S” tax status. No separate filing is required.
Most start-ups do not start as S-Corps but as C-Corps because there is no need to. At the start, founders do not care about losses because the losses build up in the company and do not disappear under the tax code. Consequently, as the corporation continues operation these accumulated loses can then be used in the future to offset income at the entity level. This is a great tax advantage!
- Limited Liability Companies (LLCs)
There are two forms of LLCs: member-managed and manager-managed. LLCs are a popular entity forms for companies that are not seeking to raise money from outside investors. However, if you are thinking of raising money and seeking outside investors, an LLC may not be your best choice. This is because investors do not like LLCs; LLCs are pass-through entities, so all profits and losses flow directly to the members and not to the investors.
- Sole proprietorship
This is the simplest form and is a non-legal entity, meaning the owner has unlimited liability for his or her actions while running the business. It is a great way to start if the entity is operated by one person and the company plans to sell a service. Sole proprietorships should not sell products because of the non-legal entity status of the sole proprietorship.
This is also a non-legal entity. The partnership itself does not file taxes because there is no entity. However, the partners are personally responsible for the profits, losses, and the taxes of the business. This form of entity is a thing of the past and is not recommended. One of the biggest risks of having a partnership is that if your partner gets sued, you get sued too!
- Limited Partnership (LP)
This entity is rarely used unless one forms a venture fund, a hedge fund, a private equity fund, or some other form of investment vehicle where one is raising money for the specific purpose of making investment. For example, real estate entities are typically LPs because they are raising money to invest in real estate. The LP is an actual entity. An LP needs a general partner (GP) in charge of managing the LP. Investors in the LP only put money into the LP and are only liable to the extent of their investment. The GP, on the other hand, is liable for everything.
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