Startup Law 101 Series: When Should I Establish An Entity For My Startup Business?

Introduction

Each founding team must decide when to establish a limited liability entity (corporation or LLC) for startup. There is no hard and fast rule to follow, but some basic guidelines will help you decide. Let’s see what they are.

Basic guidelines

The guidelines are simple, applying them less. You should work with a good business attorney to help you with your individual case.

1. If you are a sole founder and are not in business yet, please wait (but see # 5 below).

2. If you have a co-founder or two, and are still in the garage stage, ask yourself, “Is what we have worth anything?” If you have important questions, please wait.

3. If you have something that you think is good (or could be), and there are two or more of you, establish an entity. It will allow you to establish the terms of the deal between you. It will eliminate claims of the “I was promised a large chunk of the company” variety that can arise from poorly documented alliances. It will allow you to capture IP for the benefit of the company. It will help you avoid tax problems that might otherwise arise if you try to build the structure and issue shares at the same time as you contribute funds. It will focus on building your company profile. It will make it easier for you to discuss the business with other key people you hope to attract. It will provide you with a means of offering equity participation to a broader circle of people beyond the founding group. It will give you credibility when entering contracts and alliances that will help you establish the business.

4. Whether alone or with others, if you do business that creates liability risks, establish an entity.

You should use common sense here to decide when the level of activity creates risks serious enough to justify creating an entity for this reason. This is a topic to discuss with a good business attorney.

You often hear about the wisdom of protecting your personal assets from business risks through limited liability protection, and this is an important point.

However, remember that “limited liability” is primarily about disaster risks. If you have a good company and you are sued, you will defend the lawsuit and pay any normal judgment and it will cost you the same as if you did not have a limited liability entity. There is no additional “protection” here. Only if the disaster occurs (such as an overwhelming judgment) does the limited liability entity help you keep your personal assets away from the flak. Limited liability will also not help you with obligations that you may need to personally guarantee, such as an office space lease or equipment lease or a bank line of credit. It also will not help with obligations that you may incur personally within the context of a business, such as if a corporate officer assists and incites a business to violate securities laws (consult a business attorney about these types of risks) . It helps with normal contractual dealings, with the risks of tort and the like, but only when a certain liability or a sum of them is overwhelming for your company. If you just find normal liabilities, you pay them with or without a limited liability entity, unless you’re prepared to fold your business over a comparatively small matter.

However, if in doubt, configure the entity. Generally, if you have extensive activities with a lot of people, this would justify having a structure. Why? Because even when it seems safe to you, you can easily go blind. For example, you pay your people as contractors and then discover in a disaster audit three years later that they are reclassified as employees and that your company is bogged down with huge taxes and additional penalties. Out of nowhere, you have an unexpected disaster. A limited liability entity should protect you here. In such cases, prevention is better than cure.

To sum up the point of limited liability: having a limited liability entity is like having disaster insurance – it will cost you something, but it will generally protect you against big risks by keeping damage localized to your business.

5. If you are trying to raise funds, establish an entity as soon as possible or you may run into potentially serious tax risks when issuing shares to founders. The general rule of thumb here is that the earlier you make your founder equity grants, relative to funding, the better.

Factors to Consider Related to the Costs of Establishing a Limited Liability Entity

In each of the above cases, costs must be considered in relation to time. Money is needed to establish and maintain a limited liability structure.

Here are some guidelines to consider costs:

1. Don’t be silly with pennies and pounds. If you have a situation that legitimately needs a proper structure, don’t delay just because of the costs. The most remarkable situation with a startup is when you have a founding team and a viable model. In such cases, delays in the installation of the structure will likely cause problems. If cash is tight, see if your business attorney will make a deferred fee deal with you. If you wait and problems arise, the costs will be much higher.

2. Don’t assume the LLC is a panacea for costs. A quick LLC can sometimes be set up inexpensively using an attorney or an online service. With startups this can work well for a single member LLC (including husband and wife). However, for a founding team, when using restricted stocks, the LLC will be as complex as a corporate setup and there will likely be no cost savings from using the LLC format.

Also don’t forget that an LLC is basically an old-style general partnership with a limited liability limit. With multiple members, all normal issues to be negotiated in a partnership still need to be negotiated and incorporated into a properly drafted operating agreement. Who owns what? Who contributes what? Who manages what? Who is paid what? Who buys from whom and at what price? And many other issues. You can stop paying attention to this detail, but you will cause all kinds of problems doing so. So even if an LLC is the best vehicle for your startup, you won’t save much on setup costs if you get it right.

For startups with founding teams, a corporate setup is usually best. Consult with a good start-up attorney to make this assessment, but don’t let your tail wag your dog by choosing a less suitable vehicle simply to save some upfront costs.

3. With startups, use an experienced startup business attorney for any non-ultra-simple setup that you can do yourself. This will save you costs due to the efficiency of the attorney. Be sure to ask the right questions to confirm that your attorney truly has experience with early stage startups.

conclusion

Founders often make the mistake of waiting too long to establish their limited liability entity. Review the guidelines above, clarify your questions, and work with a business attorney to make the right timing decision.

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