Legal: Creating a Legal Structure
Episode #8 of the course The crash course guide to starting up by Alex Schiff
Hi all,
Today’s lesson—legal structure—is probably going to be the most boring one of all, but if you screw it up, it can create massive issues in your future.
Caveat 1: All of this is specific to the United States. If you are outside the United States, this post will probably not apply to you unless you happen to have an interest in American corporate law.
Caveat 2: I am not a lawyer, and this does not constitute legal advice.
Choosing a Corporate Structure
When deciding your business structure, there are a few considerations at play. The first is the entity structure, the most common of which are:
1. Limited Liability Company (LLC). This is what’s called a “pass-through entity” in that the organization itself is not taxed, but all profits and losses flow through to the members as individual income (and taxed accordingly). This is generally the choice for small businesses, because they’re very flexible and prevent “double taxation”—taxing both company profits and the income you draw from it. However, it can be difficult to have multiple kinds of shareholders (investors, employees, etc.), and it can make your tax situation very complicated and disadvantaged if you do give stock to employees.
2. C-Corporation. Most public companies are C-Corporations, usually based in Delaware. This is because it has the most established and uniform body of law regarding securities and governance, which are important for fundraising and issuing stock options to employees.
(Note: There are also “S-Corporations,” “Limited Liability Partnerships,” “B-Corporations,” and other structures, but they’re less common. Having known multiple people who’ve decided to choose each of these structures for various reasons, I can think of zero people who said it was a good decision in retrospect. That said, do your homework.)
Choosing Where to Register Your Business
The next choice is where your business is registered. Most LLCs are registered in the state you are operating the business, because that avoids the fees arising from being a “foreign company” operating in the state. However, some people choose to register in other states for reasons like:
• more advantageous business taxes or laws
• cheaper filing fees
• more established body of law governing LLCs
Over time, almost all startups that raise venture funding become a Delaware C-Corp, and more often than not, it’s a condition of funding. First, investing in an LLC creates a bunch of tax complications for a venture fund. Second, Delaware just happens to have the most established body of corporate and securities law, with the most legal precedent to draw from, so there is more predictability in case of a lawsuit.
(Note: Because the state government of Delaware is aware that you more or less have to do business with them, they really make you pay for it.)
Transitioning Structures
Generally, a trajectory like this is fairly common:
1. Just you: There’s no need for formal organization.
2. You and a co-founder, with negligible revenue but some intellectual property (like code) being developed: Register an LLC in the state you reside and assign the IP to the LLC, with founder vesting (more on this below).
3. You start hiring full-time employees, raise funding, or earn material revenue: Convert to a Delaware C-Corporation.
When registering an LLC in your state, you should put a basic operating agreement in place that:
• assigns all intellectual property developed previously to the company and places all future intellectual property developed within it
• declares an explicit division of ownership amongst co-founders, subject to a vesting schedule whereby that ownership (in the form of shares of stock) is accrued over time and not granted all at once
• has basic provisions in place for the transfer of that stock, governance and decision-making, etc.
The best thing to do is to consult a lawyer on this agreement, but you can find free examples online here from UpCounsel.
Overall, corporate law can be very complicated, and this lesson does not replace the need to get real legal advice, but I do hope it can be a starting point for your research. Besides, having your legal house in order is critical for tomorrow’s lesson: fundraising!
Onward!
Alex
Recommended book
Limited Liability Companies for Dummies by Jennifer Reuting
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