Startup Law 101 Series – When should I set up an entity for my startup business?
Every founding team needs to decide when to set up a limited liability entity (corporation or LLC) for their startup. There is no hard-and-fast rule to follow but some basic guidelines will help you decide. Let’s see what they are.
The guidelines are straight-forward, applying them less so. You should work with a good business lawyer to help with your individual case.
1. If you are a sole founder and have no business activities as yet, wait (but see #5 below).
2. If you have a co-founder or two, and are still in the garage stage, ask yourselves, “is what we have worth anything?” If you have any significant doubts, wait.
3. If you have something you believe is good (or may become so), and there are two or more of you, set up an entity. It will let you set your deal terms among yourselves. It will eliminate claims of the I-was-promised-a-big-part-of-the-company variety that can arise from ill-documented alliances. It will let you capture IP for the benefit of the company. It will help you avoid tax problems that may otherwise arise if you try to form the structure and issue equity at the same time you bring in funding. It will focus you on building your company profile. It will let you more easily talk up the company with other key people you hope to attract. It will give you a means of offering equity participation to a wider circle of people beyond the founder group. It will give you credibility in entering into contracts and alliances that will help you establish the business.
4. Whether alone or with others, if you are actively doing business that creates liability risks, set up an entity.
You need to use good sense here in deciding when the level of activity creates serious enough risks to warrant setting up an entity for this reason. This is an item to discuss with a good business lawyer.
You often hear about the wisdom of shielding your personal assets from business risks through limited-liability protection, and this is an important point.
Remember, though, that “limited liability” is mostly about disaster risks. If you have a good company and get sued, you will defend the suit and pay any normal judgment and it will cost you the same as if you didn’t have a limited-liability entity. There is no added “protection” here. Only if the disaster case happens (such as an overwhelming judgment) does the limited-liability entity help you by keeping your personal assets away from the flak. Limited liability also will not help you with the obligations you may need to personally guarantee, such as a lease for office space or equipment leases or a bank credit line. Nor will it help with obligations you might incur personally within a company context, as for example if a corporate officer aids and abets a company violation of securities laws (see a business lawyer about these types of risks). It does help with normal contractual dealings, with tort risks, and the like, but only where any given liability or an aggregate of them proves overwhelming for your company. If you merely encounter normal liabilities, you pay them with or without a limited-liability entity unless you are prepared to fold your company over a comparatively small matter.
If there is any doubt at all, though, set up the entity. Usually, if you have any extensive activities going with a lot of people, this would warrant having a structure. Why? Because, even when it looks safe to you, you might easily get blind-sided. For example, you pay your people as contractors and then find out in a disaster audit three years later that they are re-classified as employees and your company is stuck with huge added taxes and penalties. Out of the blue, you have an unanticipated disaster case. A limited-liability entity should shield you here. In such cases, better safe than sorry.
To sum up the limited-liability point: having a limited-liability entity is like having disaster insurance — it will cost you something but it will generally shield you against the big risks by keeping the damage localized to your company.
5. If you are attempting to raise funds, set up an entity as early as possible or you may bump into potentially serious tax risks at the time you issue stock to the founders. The rule of thumb here is that the earlier you do your founder equity grants, in relation to funding, the better.
Factors to Consider Relating to the Costs of Setting Up a Limited-Liability Entity
In every one of the above cases, costs need to be considered in relation to timing. It takes money to set up and maintain a limited-liability structure.
Here are some guidelines to factor in about costs:
1. Don’t be penny-wise and pound-foolish. If you have a situation that legitimately needs a proper structure, don’t delay just because of costs. The most noteworthy situation with a startup is where you have a founding team and a viable model. In such cases, delays in setting up the structure will likely cause problems. If cash is tight, see if your business lawyer will do a deferred-fee deal with you. If you wait, and problems do arise, the costs will be far greater.
2. Don’t assume that the LLC is a panacea for costs. A quickie LLC can sometimes be set up inexpensively using either a lawyer or an online service. With startups, this can potentially work well for a sole-member LLC (including husband-wife). For a founding team, though, where restricted stock is used, the LLC will be just as complex as a corporate setup and no cost savings will likely result from use of the LLC format.
Don’t forget either that an LLC is basically an old-style general partnership with a limited-liability cap on it. With multiple members, all the normal issues that need to be negotiated in a partnership still need to be negotiated and built into a properly drafted operating agreement. Who owns what? Who contributes what? Who manages what? Who gets paid what? Who gets to buy out whom and at what price? And many other issues. You can skip paying attention to this detail but you will invite all kinds of trouble in doing so. Thus, even if an LLC is the best vehicle for your startup, you won’t save much on setup costs if you do it right.
For startups with founding teams, a corporate set up is normally best. Check with a good startup business lawyer to make this assessment, but don’t let the tail wag the dog by choosing a less suitable vehicle simply to save on some initial costs.
3. With startups, use a seasoned startup business lawyer for any but ultra-simple setups that you can do yourself. This will save you costs because of the lawyer’s efficiency. Make sure to ask the right questions to confirm that your lawyer is indeed experienced with early-stage startups.
Founders often make the mistake of waiting too long to set up their limited-liability entity. Review the guidelines above, get your questions straight, and work with a knowledgeable business lawyer to make the right choice as to timing.