This is a guest post, reprinted with permission from our friends at Early Growth Financial Services. Founder David Ehrenberg breaks down everything you need to know about how to choose which business entity is best for your company.
When it comes to selecting the right business entity for your company, there are many options. There’s no one best choice for the type of business entity you legally choose, just the best choice for your particular company based on your goals.
To help you choose the best structure for your company, I’ve outlined the most common types of businesses. Use these summaries to help decide on the best structure for your company now and for further down the road:
1. Sole Proprietorship.
This essentially means you are your business. The company is started in your name, and all company payables come from your personal expenses. The advantages of this arrangement are that you have no one else to answer to and the arrangement is a simple one. But there are many disadvantages to mingling your personal expenses with your professional ones and with a sole proprietorship, you are personally responsible for financial issues related to your business. This kind of arrangement can quickly become messy, especially come tax-time or in the case of a lawsuit against your business.
Some sole proprietors choose to file for a DBA which just means “doing business as.” The purposes of a DBA are usually for marketing more so than for any real business reason. Your DBA is an alias that puts a more professional facade on your sole proprietorship.
Get further educated on the pros and cons of sole proprietorships here.
If you decide to bring in partners, you will need to set up a general partnership which usually includes some sort of formal partnership agreement signed by all partners (usually not requiring a state filing). This kind of business structure is also simple and easy to operate and forming a partnership will enable you to raise money by selling partnership interests.
But with a general partnership, there is still a fuzzy line between personal and business finances so all partners could find themselves in financial trouble as a result of a business issue. There’s also some potential confusion around partner roles, responsibilities, and liabilities.
3. Limited partnership.
Limited partnerships are just a variation on the theme of general partnerships. In the case of a limited partnership, you will still have general partners who are responsible for the actual business, but investors can purchase a limited partnership interest.
Limited partners aren’t embedded within a business in the same way that general partners are—the worst that can happen from a financial perspective is that they lose their original investment. And, as a founder, a limited partnership means that the involvement of such partners is minimal so you don’t lose any authority over your business. That said, entrepreneurs aren’t generally big fans of this kind of entity because there’s no built-in protection for entrepreneurs.
4. Limited Liability Companies (LLC).
These kinds of companies provide a more formalized legal structure which offer some protection from liability. Here, finally, is a structure that separates your personal assets from your company’s debts. Also, with a Limited Liability Company, while there is an agreement that governs operations, there’s no buy-sell which can lead to issues if all member aren’t contributing equally to the business. LLCs don’t have to have boards, hold annual meetings, or record minutes.
In an LLC, there is no limit to the number of members (as opposed to “partners”) and ownership can be broken down into different classes which gives entrepreneurs some flexibility when it comes to raising equity financing. An LLC makes sense if your company is only at the stage in your development process where you will have the ability to attract angel investors, but not VCs (i.e. you are expecting that your business will generate losses). Angels will be motivated by the potential tax losses; VCs will not. VCs still prefer purchasing stock in a corporation over purchasing membership interests.
If you’re in your early stages (particularly pre-revenue) and have your sights set on venture capital, opting for a C-corp makes good sense. VCs are comfortable investing in this type of company. And there are other advantages to this kind of entity outside of funding including a separation between debts, tax, and legal structure from your personal assets.
There is an added level of structure that goes along with a C-corp such as the need to start holding annual meetings and record minutes. The potential downside is that the C-corp is taxed on its corporate profits, but when you’re just starting out, you likely don’t have any profits to be taxed on so this isn’t really a problem.
Without getting into too much detail, suffice to say that S-corporations are thus named because of how they take advantage of Subchapter S of the federal internal revenue code which allows them to avoid taxation of corporate income (at the federal and state level).
This is a great option for you if you are fine limiting the number of shareholders and in need of liability protection. An S corporation separates your personal assets from your company’s debts and offers some tax benefits (which may not be that big of a deal if you’re in the early-stages and not making any money anyway). S-corps are not so great if you’re seeking venture capital because you’re limited to one class of stock which eliminates your ability to do multiple financings.
It is possible, down the road, to convert your company into a different entity so don’t worry too much about being stuck with your decision. That said, it’s worth sitting down and thinking about your financial projections and goals (and possibly meeting with a lawyer or finance professional) to figure out which business structure is going to be most helpful for your business right now.
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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.