Introduction
Each founding team must decide when to establish 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.
Basic Guidelines
The guidelines are direct, applying them less. You should work with a good business attorney to help you with your individual case.
1. If you’re a sole founder and not in business yet, wait (but see #5 below).
2. If you have one or two co-founders and you’re still in the garage stage, ask yourself, “Is what we’ve got worth anything?” If you have significant doubts, wait.
3. If you have something that you think is good (or could be), and there are two or more of you, create an entity. It will allow you to establish the terms of your deal with each other. It will eliminate the “I was promised a large part of the company” claims that can arise from poorly documented partnerships. It will allow you to capture IP for the benefit of the company. It will help you avoid tax problems that might otherwise arise if you try to form the structure and issue shares at the same time you raise funds. It will focus on building your company profile. It will allow you to more easily discuss 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 founding group. It will give you credibility when making 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, establish an entity.
You should use common sense here to decide when the level of activity creates risks serious enough to warrant creating an entity for this reason. This is a topic to discuss with a good business attorney.
You often hear about protecting your personal assets from business risks through limited liability protection, and this is an important point.
Remember, though, that “limited liability” is primarily about disaster risks. If you have a good company and you are sued, you will defend the lawsuit and pay any normal judgment and it will cost you the same as if you did not have a limited liability entity. There is no additional “protection” here. Only if disaster strikes (such as an overwhelming lawsuit) does the limited liability entity help you keep your personal assets out of harm’s way. Limited liability also won’t help you with obligations you may need to personally guarantee, such as an office space lease or equipment lease or a bank line of credit. Nor will it help with obligations you might personally incur within a company context, such as if a corporate officer aids and abets a company to violate securities laws (consult a business attorney about these types of risks ). It does help with normal contractual transactions, liability risks and the like, but only when a particular liability or set of liabilities becomes overwhelming for your company. If you just find normal liabilities, you pay them with or without a limited liability entity, unless you’re prepared to close your business over a relatively small matter.
However, if there is any doubt, configure the entity. Generally, if you have extensive activities with many people, this would justify having a structure. Why? Because, even when it seems safe to you, you can easily be surprised. For example, you pay your people as contractors and then find out in a disaster audit three years later that they are reclassified as employees and your company faces huge additional taxes and penalties. Out of nowhere, he has an unexpected disaster case. A limited liability entity should protect you here. In such cases, prevention is better than cure.
To summarize the limited liability point: Having a limited liability entity is like having disaster insurance: It will cost you something, but it will generally protect you against the big risks by keeping the damage localized to your business.
5. If you are trying to raise funds, set up an entity as soon as possible or you may face potentially serious tax risks when issuing shares to founders. The general rule of thumb here is that the sooner you make your founder’s equity grants, relative to funding, the better.
Factors to Consider Regarding the Costs of Establishing a Limited Liability Entity
In each of the above cases, the costs must be considered in relation to time. Money is needed to establish and maintain a limited liability structure.
Here are some guidelines to keep in mind about costs:
1. Don’t be silly about pennies and pounds. If you have a situation that legitimately needs proper structure, don’t delay just because of costs. The most notable situation with a startup is when you have a founding team and a viable model. In such cases, delays in the installation of the structure are likely to cause problems. If cash is tight, see if your business attorney will make a deferred fee deal with you. If you wait and problems arise, the costs will be much higher.
2. Don’t assume the LLC is a cost panacea. Sometimes a quick LLC can be set up cheaply using a lawyer or an online service. With startups, this can potentially work well for a single member LLC (including husband and wife). However, for a founding team, where restricted stock is used, the LLC will be as complex as a corporate setup and cost savings are not likely to be realized by using the LLC format.
Also, don’t forget that an LLC is basically an old-style general partnership with a limited liability limit. With multiple members, all the normal business that needs to be negotiated in an association still needs to be negotiated and integrated into a properly drafted operating agreement. Who owns what? Who contributes what? Who manages what? Who charges what? Who can buy from whom and at what price? And many other issues. You can skip paying attention to this detail, but you’ll invite all sorts of trouble doing so. So 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 setup is usually best. Consult a good startup attorney to make this assessment, but don’t let the tail wag the dog by choosing a less suitable vehicle simply to save on some upfront costs.
3. With startups, use an experienced startup attorney for any setup except ultra-simple ones, which you can do yourself. This will save you costs due to the efficiency of the attorney. Be sure to ask the right questions to confirm that your attorney has experience with early-stage startups.
conclusion
Founders often make the mistake of waiting too long to set up their limited liability entity. Please review the guidelines above, clarify your questions, and work with an experienced business attorney to make the right decision on timing.
