Choosing the Right Entity for Your Start-Up
Jeffrey R. Glassman
 I
just spent the last few hours writing an article that highlighted
the distinctions among various entities including a sole
proprietorship, a partnership, an S corporation, a C corporation,
and a limited liability company (or “LLC”).
Then it dawned on me: It’s the LLC, stupid!
For most start-up companies, the LLC is really the only
entity that matters or makes any sense.
Why not a sole proprietorship? Because you don’t
need unlimited personal liability in order to get your business
off the ground. What about a partnership? While the “pass
through” tax benefits are nice, you and your partners
can obtain the same tax benefits with an LLC and limit
your personal liability.
I know what you’re thinking. If limited liability
is my concern, then why not a C corp? On the one hand, you’re
right. Operating as a corporation does provide you with
limited liability (that is, shareholders are not liable
for the corporation’s debts). However, there is a
major drawback to C corps. They are taxed as corporations
(first level of taxation) and then you, as an individual,
are taxed on the distributions you receive from the C corp
as a shareholder (a second level of taxation). Double the
taxation is not double the fun when you’re starting
a business.
Well, what about an S corp? With an S corp you get the
“pass through” tax benefits of a partnership
and the limited liability of a C corp. However, if your
company needs capital from outside investors in order to
grow, the S corp only allows for one class of stock. This
can present a major stumbling block for investors who will
likely want special treatment and certain priorities and
rights before they hand over millions.
As a result, what options are start up companies left with?
Ladies and gentlemen, I give you the LLC. A combination
of the “pass through” tax benefits of a partnership,
the limited liability of an S corporation, and the flexibility
of a C corp. Let me take you through a brief hypothetical
to show you what I mean.
Four people want to start a new technology company together
called “Newco.” John has developed a revolutionary
technology that will make the Internet obsolete. Paul is
currently a management consultant and is ready to leave
his business to become Newco’s CEO. George is a Senior
VP of Sales and Marketing for a Fortune
500 company and wants to head up Business Development. And
Ringo made millions through the manufacturing and distribution
of percussion instruments and wants to invest $5 million
in Newco as a “passive” investor (not involved
in the day-to-day operations of Newco).
While Ringo recognizes that John, Paul, and George will
be making a substantial contribution to the success of Newco,
Ringo still wants control over certain important decisions
Newco makes, wants special rights and priorities associated
with his ownership interests in Newco, and wants a clearly
defined exit strategy. In addition, Ringo wants the investment
to come from his investment company, Ringo Investments,
Inc., a C corporation in which Ringo owns 100% of the stock.
Is this scenario complicated for certain entities? Yes,
but it is not so complicated for the LLC.
Let’s talk about ownership rules first.
S corp shareholders are restricted to individuals, estates,
certain trusts, and charitable organizations. However, any
person or entity (including partnerships, LLCs, or corporations)
can be an LLC member. Therefore, an S corp could not accept
the $5 million from Ringo Investments, Inc. in exchange
for shares of Newco. However, as an LLC, Newco can easily
make Ringo Investments, Inc. a member.
Moreover, LLC membership interests can be acquired in exchange
for property, future services rendered, or any other obligations
including a promise to pay. Corporate stock, however, cannot
be issued for future services or an unsecured promise to
pay. Therefore, John can donate to, and continue to develop
his technology on behalf of, Newco, LLC and Paul and George
can simply agree to provide management and business development
services to Newco, LLC, respectively, all in exchange for
their membership interests.
These non-monetary contributions in exchange for a percentage
of the company would not be possible with an S corp. Rather,
John, Paul and George would need to pay for their shares
or provide promissory notes secured by their personal assets
in exchange for their shares.
What about the management of Newco? Instead of
Shareholder’s Agreements and Bylaws, LLC’s use
the Operating Agreement as their vehicle for describing
all of the rights, interests, and obligations that its members
have. The Operating Agreement can be customized to fit the
particular needs of any start up company.
For example, Newco’s Operating Agreement could provide
that the day-to-day business and affairs shall be managed
by John, Paul, and George, but that all four co-founders
(including Ringo as CEO of Ringo Investments, Inc.) will
sit on the Board of Managers and determine together how
to deal with important decisions facing the company. These
“important” decisions can be anything the co-founders
want them to be including whether to enter into large, long-term
contracts (including lease agreements), whether to borrow
money above a certain threshold amount, whether to raise
new investment capital from a source other than Ringo, or
whether to sell, merge, or dissolve the company.
The Operating Agreement can also establish the criteria
for admitting new members into Newco by way of a vote of
a majority in interest, give members a right of first refusal
to purchase a departing member’s membership interests,
and give members the right to assign the economic interests
associated with their membership interests to third parties
(rights to share in profits, losses, distributions, etc.).
What about Ringo’s need for special treatment
and an exit strategy? An S corp is limited to one
class of stock (although it can have separate voting rights
within that class). LLC’s, however, can have different
classes of membership interests. This flexibility is perfect
for catering to Ringo’s “special needs.”
As an LLC, Newco can issue Class A membership interests
to Ringo and Class B interests to John, Paul, and George.
As a Class A interest holder, Ringo could insist on all
kinds of special treatment that his three partners would
not necessarily receive including, among others, dividend
preferences (control over when and how dividends would be
declared and distributed); liquidation preferences (preferential
claims to payments received by Newco upon dissolution or
an acquisition); voting rights (control over whether or
not new members should be admitted to Newco, control over
major transactions like a sale, merger or dissolution, control
over appointment of new managers of Newco, and control over
any changes to Newco’s Operating Agreement); and anti-dilution
rights (insurance that Ringo’s percentage interest
in Newco will not be reduced if the company needs to raise
new capital from another source).
Am I oversimplifying things? Yes. Are there certain advantages
to having a corporation? Yes. Should you consult with your
accountant to determine what entity makes the most sense
for your new company? Always. But for most start ups—especially
those who might be interested in raising capital from passive
investors—the LLC is the “right entity.”
So choose it.
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Jeffrey R. Glassman is a Partner at the law firm, Moldo,
Davidson, Fraioli, Seror & Sestanovich. You can find
out more about Glassman and the firm at www.mdfslaw.com.
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