Start Your Startup Right: Defining Corporate Structure

By Paul Johnson, Partner, Procopio, Cory, Hargreaves & Savitch LLP

(This advice does not displace competent legal counsel. Discuss your startup structure in detail with your attorney)

There's no better time to think about your startup's exit than the day you decide to incorporate your business. Thinking about likely exits now will help you avoid early pitfalls.

One of the first things you'll be thinking about are your goals. How will you make money? Who will sell your products? How long will it take to get where you want to go? Is your big idea enough to be a standalone company indefinitely? Will you raise money in an IPO and take over the world?

Do you anticipate that your company will be acquired by a "gorilla" in the industry? Are you a piece of a larger puzzle?

Will your business create cash to pay dividends rather than requiring you to sell your stock? (In my humble opinion, plan to succeed without being sold. Not being forced to sell gives you more leverage if you do sell.)

The business models described above would all require a different legal structure. Companies that provide a return through dividends are often different from IPO or Merger and Acquisition candidates.

Service businesses, mom and pop lifestyle businesses, dealerships or other types of small businesses may not ever have the 10x returns that a venture capitalist firm is looking for. If you plan on making money through dividends and not growth, you may want to consider establishing a "pass through" vehicle for your startup.

Types of Entities

Here are some examples with advantages or disadvantages of each corporate structure type:

C Corporations

A C corporation (or C-corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations are the most common type of corporation but are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.

Advantages:

Shareholders are not taxed on company earnings until paid in dividends
C Corporations operate under familiar rules of the game: 1 share = 1 vote, 1 director = 1 vote and officers have set roles
C Corporations reduce risk and increase efficiency - rules are set by statute and not by contract
Venture capitalists prefer this corporation structure

Disadvantages:

C Corporations are taxed at the corporate level and stockholder level when dividends are provided (providing a double tax)
Losses also stay at the corporate level: and can’t be put on the owners’ tax return

Pass Through Vehicles

Pass through entities like an S corporation pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

Advantages:

S corporations are formed like a C corporation with 1 vote per share
S corporations are subject only to tax at shareholder level (with some exceptions)

Disadvantages:

S corporations must meet strict requirements

Limited Liability Corporations (LLCs)

A Limited Liability Company (LLC) is the United States-specific form of a private limited company. It can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. It is not a corporation under state law. In some states, businesses that require a professional license may be required to create a professional limited liability company (PLLC). It is a legal hybrid, containing some characteristics of a corporation and a partnership.

Advantages:

May be more suited for companies with an individual owner
Formed like a partnership with an agreement among owners
Subject only to tax at the owner level (with some exceptions)
It has fewer requirements than S corporations
Both LLCs and S corporations avoid the double tax when selling assets and can lead to better exit values
are formed like a C corporation with 1 vote per share
S corporations are subject only to tax at shareholder level (with some exceptions)

Disadvantages:

A difficult structure for investors and investor exits

Where to Incorporate

It is well known that the state of incorporation does matter for C corporations. Delaware is the preferred state, with a majority of NYSE, NASDAQ and Fortune 500 being incorporated there. Delaware has well established "rules of the game."

As you can see, defining your corporate structure is no small decision and can have lasting impact on your company's owners, profits and taxes. Get started right before you get your startup rolling.