How to choose your business structure

What is the best legal structure for startups?

The entity type can be very confusing for new entrepreneurs starting a business. This is often compounded by the wide variety of highly generalized and opinionated advice scattered across the web today. Your choice can make a big difference later, especially if you plan to raise capital. Don’t let this relatively small step in the journey slow you down.

Types of legal entities to choose from

Here are some of the most common business start-up options. Before choosing one, I strongly recommend that you seek advice from a good corporate lawyer.

Individual business

This is one of the most common default modes of operation for independent professionals, individual entrepreneurs, and new small business owners. It is considered the easiest way to get started, with the lowest cost and the least amount of paperwork and management overhead. The cons include no personal liability protections and no ability to scale by adding additional owners.

Partnerships

Partnerships are another common form of entity for smaller, closely held businesses. However, unless formed as a Limited Liability Company (LLP), owners may be fully exposed to liability. Each partner pays its own income taxes as a flow-through entity.

Limited Liability Companies

LLCs have become much more popular over the past two decades. Many of New York’s wealthiest real estate businesses are structured as LLCs.

These structures provide liability protection like a C corporation, with more flexibility in how taxes are chosen to be levied. These can be good investment vehicles with one managing member actively making operational decisions, while others can participate as passive investors.

S-body

S corporations are more of a hybrid business structure. They are limited to only 100 owners and one class of shares. This makes them very unattractive to most venture capitalists and angel investors. Taxation may be preferable with the possibility of avoiding double taxation of C Corps. Although entrepreneurs are still hampered by the meetings and extra paperwork of a regular C corporation.

C-Corporations

C corporations are what you will encounter with most public companies. There is more organizational burden and the potential for more taxes. Although the flexibility of share size and classes makes them much more attractive to investors. If you are looking to go the hyper growth route by raising venture capital funds, this may be the best route.

In this regard, when seeking financing, the corporate structure will also be shared in the documents of investors. This can be part of your pitch deck appendix. For a winning deck, take a look at the pitch deck template created by Silicon Valley legend Peter Thiel (see here) which I recently covered. Thiel was Facebook’s first angel investor with a check for $500,000 that turned into over $1 billion in cash. Additionally, I also provided commentary on a pitch deck from an Uber competitor that raised over $400 million (see here).

Decisive factors when choosing a business structure

While this shouldn’t be a step that slows your business down, here are some of the factors to consider before choosing.

Taxes

Ultimately, in business and investing, it’s not how much you earn, but how much you can keep that is most important. Getting trapped by double taxes and higher tax rates can be really frustrating. Some structures may also allow losses to be carried forward from early years to years where there are profits and tax bills.

Costs

It is relatively inexpensive to set up any of the above business structures. How you do it and who you do it will make most of the cost difference. Obtaining nonprofit status, creating trusts, or relocating can increase expenses. You will also need to file annual returns and pay for renewals with certain types of companies. These fees may vary depending on the state or jurisdiction in which you are training.

Management burden

The management burden can also increase ongoing costs. If you’re convinced this is a small part-time hobby, you probably don’t want to be overwhelmed with additional meeting, registration, and paperwork requirements.

Flexibility

Some entity types provide more switching and scaling capabilities. For example, moving from an S Corp to a C Corp as you grow.

Future needs and goals

Know your goals before you incorporate. If you know your plan is to raise capital or go public as an exit strategy, it may make more sense to choose an entity that allows you to do so without additional steps or delays afterwards. Don’t do everything else right to set up a great fundraising campaign and then run into hurdles because your entity has it all wrong.

How to do

It is super simple to set up one of these types of structures today. In minutes, you can start your own business online and get a tax ID. Often all for less than a few hundred dollars.

Of course, that doesn’t mean the DIY route is the smarter route to take. A good corporate lawyer will know all the right questions to ask to ensure that documents are properly filed from the start and optimally for the desired needs. Putting this expense into perspective is really negligible.

Summary

There are a variety of options when it comes to choosing your business structure. Each carries its own advantages and disadvantages. Know what your drivers are before selecting.

Every accountant and lawyer may have their own opinion of which ones they prefer or know best. Always get personalized advice and legal advice from corporate lawyers, CPAs and a consultant with start-up experience to ensure the format is right for you.

Listen to it DealMakers Podcast to find out how today’s most successful entrepreneurs have structured their businesses and what advice they would give their youngsters if they had to start over.