* This post is part of an ongoing legal column called “The Legal Pad” here on Technori that digs deeper into the most common mistakes startups make when facing legal issues. Rather than spell out the basics, this series aims to pull back the curtain and focus on the end results that occur when mistakes are made. *
By now, even the least knowledgeable entrepreneurs know that they need to form some type of business entity in order to protect their personal interests. But, many rush through the decision of choosing which entity fits their business without much thought. They hear about LLCs and corporations, and often believe that choosing one or the other will lead to the same result. Even worse, they believe those types of business structures are one in the same.
In the startup space, and especially at technology-based startups, a big mistake entrepreneurs make is starting their businesses as LLCs. Why? Put yourself in the shoes of a venture capitalist or institutional investor and consider two fundamental issues: taxes and predictability.
Let’s run through the basics. On a very simple level, LLCs allow owners to shield themselves from personal liability while passing their profits through the business and directly to their personal tax returns. This results in the profits of the business being taxed only once—at the owner level. A corporation is taxed at the corporate level and at the shareholder level upon distribution of the profits. So, every dollar in profit ends up being taxed twice. That fact alone makes an LLC very attractive and is primarily why the LLC structure has rapidly increased in popularity over the last two decades.
Yet, many entrepreneurs don’t consider the practical effect of passing profits through to owners. What if your business nets $20,000 and you want to retain those earnings within the business to fuel growth? Generally, the owner is still liable for his or her share of taxes on the $20,000, even though the owner never received any distributions to use for paying those taxes (complex tax strategies aside).
This becomes a significant issue for investors who have multiple investments across several startups. Imagine the excitement an investor must feel when she realizes 7 of her 10 portfolio startup LLCs have turned a profit. Then, imagine the frustration she will endure when she receives 7 separate K-1 tax forms outlining her aggregated year-end tax liability. Not to mention the administrative headache of tracking these documents.
This is a major reason why many investors prefer startups that are formed as corporations. When a corporation turns a profit, those profits are taxed and paid for out of the corporation’s earnings. The investor does not realize a tax liability until their share of the profits has been distributed. Now the investor has cash on hand to pay the tax liabilities.
How hard would it be to win a board game if you did not know the rules? Really tough! You would probably prefer to read the rule book beforehand. The same is true with investors.
In an LLC, the rules that regulate an owner’s rights are contained in a unique contract known as an operating agreement. This document is typically customized by the members who own the LLC, and varies from business to business. Investors would have to read a new rule book every time they were pitched an LLC. And, if the operating agreement needs modification, then lawyers are called in and the cost of the deal increases.
On the other hand, all corporations are governed by the same rules: state law. Sure, state law varies from state to state, but the variances are small relative to the boundless creativity of an operating agreement. Additionally, many startups choose Delaware as their state of incorporation, as this state’s laws have been deemed some of the most favorable to corporations. The result is predictability and decreased transactional costs. Thus, in a world where picking successful startups is anything but predictable, having a consistent set of rules is desired.
But What If I Don’t Plan to Seek Institutional or VC Investment?
True, there are scenarios when choosing a corporation over an LLC may not fit the needs of a business. One example is when the business anticipates limiting the number of investors to a small group for an extended period of time or not seek significant outside investments. Or, if an entrepreneur plans to bootstrap the operation, then he or she may wish to offset personal income taxes generated by other means with the losses generated by the startup.
Offsetting taxes may also be advantageous to an angel investor who prefers to use the losses of the business against their personal taxes. These cost-versus-benefit scenarios need to be considered immediately after inception of the business.
I Already Filed as a LLC, But I Plan on Pitching to VCs!
Relax, the good news is that this can be fixed. The bad news is that it does require time spent by lawyers drafting documents and spending money on additional filing fees. And the more hoops to jump through, the more the business will bear the burden of costs that could have been avoided.
The decision is rather cut and dry: if an entrepreneur plans to seek investments from venture capitalists or institutional investors, setting the business up as a corporation from the start will prevent unnecessary headaches and legal fees in the future.