S&W Startup Series Choice of Legal Entity December 11, 2014
Ben Armour, Corporate [email protected] (617) 338-2423
Brian Hammell, Tax [email protected] (617) 338-2462
Agenda
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Reasons to Form a Legal Entity Why Can’t I Just Use LegalZoom? Basic Assumptions Common Types of Legal Entities
› Characteristics › Method, Cost and Ease of Formation
How to Decide Which Entity to Choose Changing Legal Entities
Reasons to Form a Legal Entity
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Potential to Reduce Personal Liability
Potential to Establish Credibility
Provides Tax Flexibility
Facilitates Management and Control
Why Can’t I Just Use LegalZoom?
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Why Can’t I Just Use LegalZoom?
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Why Can’t I Just Use LegalZoom?
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Why Can’t I Just Use LegalZoom?
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Internet is Slow Generally-Available Forms are not Customized Limited and Incomplete Explanations
Basic Assumptions
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Founders will want to pursue the “Silicon Valley model” › Angel › Venture Capital › Family Funds
Founders will want to be a target in an M&A transaction › Strategic › Portfolio › Acqui-hire
Founders will want to take the company public Founders will not want to run a “family business” for
decades
Common Types of Legal Entities Characteristics
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Sole Proprietorship
Partnership › General Partnership › Limited Partnership
Corporation › C Corporation › S Corporation
Limited Liability Company
Sole Proprietorship Characteristics
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Default Liability
› Unlimited personal liability for business debts can be mitigated through procuring insurance
Credibility › Few formalities could make a sole proprietorship appear
unsophisticated
Tax Consequences › Business is not a separate entity for tax purposes; income is taxed to
sole proprietor
Management and Control › Sole proprietor has autonomy › Business terminates upon sole proprietor’s death; no ownership
transfer
General Partnership Characteristics
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Organization › Two or more parties who voluntarily agree to own and run a for-profit business
in which they equally share management duties and profits or losses
Liability › Unlimited personal liability
Credibility › Partnership Agreement lends some level of sophistication
Tax Consequences › “Pass-Through” tax treatment available
Management and Control › Equal right of each partner to manage the business; simple majorities usually
prevail
Profits and Losses › General Partners share equally (unless otherwise agreed)
Limited Partnership Characteristics
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Organization › At least one General Partner (who provides capital and manages the business)
and one or more Limited Partners (who provide only capital)
Liability › General Partners have unlimited personal liability; Limited Partners risk only
their capital contributions
Credibility › Partnership Agreement lends some level of sophistication
Tax Consequences › “Pass-Through” tax treatment available
Management and Control › Equal right of each General Partner to manage the business; Limited Partners do
not manage the business
Profits and Losses › Usually shared based upon the value or percentage of each partner’s capital
contributions to the business
Corporation Characteristics
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Organization › Formed by one or more parties under state law
Liability › Limited liability for shareholders
Credibility › Well-recognized, well-respected; preferred form of entity for VCs
Tax Consequences › C Corporation: Double taxation › S Corporation: “Pass-Through” Taxation
Management and Control › Shareholders, directors and officers
C Corporation vs. S Corporation Characteristics
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Organization › S Corporation has 100-shareholder limit › S Corporation shareholders must be U.S. citizens or residents
Tax Consequences › S Corporation: “Pass-Through” Taxation › Corporation does not pay taxes; each shareholder will receive a Form K-1
reporting the business’s income to such shareholder as a result of the investment
Management and Control › Corporation must elect S Corporation status with the IRS
Profits and Losses › C Corporation: no pressure to distribute cash to cover taxable income › S Corporation: generally S Corporation shareholders can use losses, deductions,
credits and other tax benefit items from the business to offset other income on their individual tax returns
Limited Liability Company Characteristics
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Organization › Formed by one or more parties under state law
Liability › Limited liability for members
Credibility › Well-recognized, well-respected; not a favorite of VCs
Tax Consequences › “Pass-Through” Taxation
Management and Control › Single-Member LLC is easy (LegalZoom is okay!) › Members, managers or directors, and officers
Common Types of Legal Entities Method, Cost and Ease of Formation
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Sole Proprietorship: easy and cheap › Default; no formation action required (i.e., no filings) › Obtain licenses and permits; obtain EIN if there are employees › Must pay self-employment tax on your own income
General Partnership: moderately easy and cheap › No formation action required (i.e., no filings) › Obtain licenses, permits and EIN › Must pay self-employment tax on your own income › Partnership Agreement recommended
Limited Partnership: moderately easy and cheap › No formation action required (i.e., no filings) › Obtain licenses, permits and EIN › Must pay self-employment tax on your own income › Partnership Agreement recommended
Common Types of Legal Entities [cont’d] Method, Cost and Ease of Formation
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C Corporation: Goldilocks › Prepare and file Articles of Organization › Filing fees, annual report filing fees, annual corporate excise tax
[aggregate minimum of approximately $1,000] › Obtain licenses, permits, EIN › Must follow corporate formalities
S Corporation › Same corporate formalities as for a C Corporation › Must file Form 2553 to elect S Corporation status
Limited Liability Company: Difficult and Expensive › Prepare and file Certificate of Organization › Filing fees, annual report filing fees [aggregate minimum of approximately
$1,000] › Prepare a Limited Liability Company Agreement › Obtain licenses, permits, EIN
How to Decide
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Not Viable: Sole Proprietorships › Too much liability › Not enough credibility › Limited access to capital
Not Viable: General Partnerships and Limited Partnerships › Unlimited liability for general partnerships › Difficulty transferring ownership › Partners bound by law of agency › Limited access to capital
How to Decide [cont’d] Formalities
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C Corporation: › (-) adherence to corporate formalities
S Corporation: › (-) adherence to corporate formalities
Limited Liability Company: › (+) fewer organizational formalities › (+) operating agreement governs all issue with regard to LLC
Formalities Conclusion: › After the initial formation, LLCs are generally easier to operate than Corporations
How to Decide [cont’d] Taxation
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C Corporation: › (-) double level of taxation › (-) taxable event when distributing appreciated property from entity › (+) no Form K-1 for stockholders
S Corporation: › (+) one level of taxation at stockholder level › (-) taxable event when distributing appreciated property from entity › (-) stockholders taxed on company’s income and must complete a Form K-1
Limited Liability Company: › (+) one level of taxation at member level › (+) can generally distribute appreciated property without triggering gain › (-) members taxed on company’s income and must complete a Form K-1
Taxation Conclusion: a consideration but not the key consideration › Applicable only when C Corporation makes distributions, or dividends, of
earnings and profits to shareholders › A C Corporation that is not generating a lot of cash will likely not be in the
position of making distributions › BUT, some VCs might not be interested in LLCs because of the Form K-1
requirement
How to Decide [cont’d] Loss Pass-Through
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C Corporation: › (-) no pass-through of losses
S Corporation: › (+) generally, losses, deductions, credits and other tax benefit items may offset
other income on individual tax returns
Limited Liability Company: › (+) generally, losses, deductions, credits and other tax benefit items may offset
other income on individual tax returns
Loss Pass-Through Conclusion: › S Corporation and LLC form of entity are preferable if loss pass-through is a key
factor, but loss pass-through is unlikely to be a key factor › BUT, VCs might prefer limits on loss pass-through
How to Decide [cont’d] VC Appeal
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C Corporation: › (+) can issue convertible preferred stock (i.e., multiple classes of stock), the
typical vehicle for venture capital investment
S Corporation: › (+/-) will automatically convert to a C Corporation if receives VC investment
Limited Liability Company: › (+) can issue multiple classes of stock › (-) VCs typically will not invest in LLCs and may be precluded from doing so under
various VC fund documents
VC Appeal Conclusion: › C Corporation form of entity is the path of least resistance in terms of VC Appeal,
but VC funding is difficult to obtain and may take at least one year
How to Decide [cont’d] Reinvestment of Capital
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C Corporation: › (+) can retain operating capital without pressure from stockholders
S Corporation: › (-) pass-through taxation may make conservation of operating capital difficult
because S Corporations typically must distribute cash to enable stockholders to pay taxes on pro rata share of S Corporation’s income
Limited Liability Company: › (-) pass-through taxation may make conservation of operating capital difficult
because LLCs typically must distribute cash to enable members to pay taxes on pro rata share of LLC’s income
Reinvestment of Capital Conclusion: › C Corporations are generally better if conservation of capital is a key factor
How to Decide [cont’d] Equity Compensation
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C Corporation: › (+) can issue traditional stock options and incentive stock options
S Corporation: › (+) can adopt traditional stock option plans and can issue incentive stock options
Limited Liability Company: › (-) difficult for LLCs to issue stock options, and incentive stock options are not
available
Equity Compensation Conclusion: › C Corporations and S Corporations provide more flexibility from an equity
compensation perspective
Bonus: Fringe Benefits › C Corporations and S Corporations have more favorable treatment of fringe
benefits
How to Decide [cont’d] Raising Equity, Going Public
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C Corporation: › (+) can engage in traditional equity financings
S Corporation: › (+) can easily engage in equity sales; does not have to convert to a corporation to
issue equity
Limited Liability Company: › (-) complicated to sell equity or go public; as a practical matter, LLC needs to
transfer its assets to a new corporation, merge with a new corporation, or engage in a state law conversion before entering the public equity markets
Going Public Conclusion: › C Corporations and S Corporations have more favorable paths to going public
Changing Legal Entities
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Converting to a C Corporation: › S Corporation: easy to convert to a C Corporation; automatic conversion after
accepting VC money › LLC: must transfer its assets to a new corporation, merge with a new
corporation, or engage in a state law conversion › LLC: may raise issues relating to conversions of capital accounts into
proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents
Thank You
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Key Contacts › Ben Armour, Corporate
[email protected] (617) 338-2423
› Brian Hammell, Tax [email protected] (617) 338-2462
› Kristen Young, Corporate [email protected] (617) 338-2427