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What kind of corporate entity should we choose?

Some friends of mine are looking into developing some new manufacturing technology (software) to sell to manufacturing companies worldwide. It is early days and they have a ways to go to get off the white board and to a salable product. The company is spending no money now, just time from the founding team. But that will likely change soon. Despite the desire to "bootstrap", the reality is that they may well need to raise some funds at some point, although they don't know when.

So my question is, just what is the best way to incorporate? Sole proprietor (doesn't sound right, but hey, I have no idea)? LLC? C Corp? Partnership? And in what jurisdiction? Some of the founders are in CA, others in NY. Any insight would be appreciated.
 

Answers

Jeff Taylor
Title: CFO
Company: Communications Co.
(CFO, Communications Co.) |

My experience with formation is all with CA-based technology companies. Around here we tend to incorporate a company that we wish to sell or grow to an IPO (important up-front considerations) as either an LLC or a C-corp. Some folks start with LLCs b/c they are cheaper to incorporate from a filing fee and legal fee standpoint and they are easy and inexpensive to flip to a C-corp at a later date. However, if it ends up staying small, having no outside investors or simply being folded, the LLC structure will likely prove to have been less costly and complex while still giving you upside options (like conversion to C-corp). One other point about LLCs is that they are like partnerships (at least in CA) and they are member managed (unless you appoint non-member managers) so it is very clear who owns what and who runs what b/c there are typically no outsiders and there is no board of directors.

The C-corp tends to be the most popular b/c it A) Is what everyone is used to (not to be under-appreciated), B) Is easily invested in b/c you can easily create new shares w/ all sorts of rights, C) Provides for a board of directors, which is de rigueur if you are seeking institutional or even angel investment as someone will take a board seat in each investment round, D) Can utilize a standard stock option plan which can be easily managed by the board, E) Is easily folded into another C-corp in an M&A transaction (which represent the majority of "exits" for companies that "make it", and F) Is the corporate structure you would need to go public, the other exit for companies that make it.

I'm sure there are many other ways to skin this cat but this is my $.02.

Robert Hawn
Title: Partner
Company: Strategy Law, LLP
(Partner, Strategy Law, LLP) |

Because I’m an attorney, I need to start out by saying these comments do not create an attorney client relationship, and are for general educational purposes only. They are intended to provide some background to help you when you speak with your counsel and other advisors, but these comments should not be relied upon with respect to your particular situation.

I generally agree with Jeff’s thoughts. Entity choice often revolves around two concepts. First, how will the owners get their money out? If it is through growing the company and selling it, or taking it public, a corporation should be examined. If it is through taking out cash each year from operations, then some type of pass-through mechanism should be examined, such as a limited liability company, or, in certain cases, an S corporation or partnership vehicle.

Second, will the founders bring in outside investors? If so, a limited liability company should be examined, but if successive rounds of investment will occur, then it is likely a corporation will need to be used. If other than living breathing humans (and some trusts) will be acting as investors, then likely a C corporation will be used.

Once the above questions are answered, the choice of entity typically becomes apparent. Here in the valley, start-up companies will require successive rounds of outside investment from venture capital and other institutions, so a C corporation is favored.

I would be very careful about the LLC to C corporation conversion route, because complications (and expense) often occur as a result of operational issues which arise during the course of operating the LLC (such as the need to get third party consents for executory contracts, conversion of equity incentives, etc.). If you decide to go this route, your expense will undoubtedly be lower the earlier in your company’s life cycle you decide to convert, all other things being equal.

Hope this helps when you speak with your counsel and your tax and accounting advisors.

Jim Wall
Title: Board Trustee
Company: FERF
(Board Trustee, FERF) |

You mentioned sales being worldwide. If that is a realistic expectation, then you should add to your consideration whether to incorporate a parent company offshore (Cayman or others) with a US subsidiary. It is not that diffiult for skilled international tax advisors to do this, but it will add complexity and several thousand of additional upfront costs without immediate tax benefits as all of your income will likely initially be fully taxable in the US. But if the project is expected to have substantial revenue you may well find it will improve your exit return greatly. You will need to consult with tax advisors who are well versed in international taxation -- don't just use someone who is expert in US taxation alone. For example, any of the Big 4+2 can assist. You need to make the decision at this stage of the project, deciding later will make the task far more difficult if not practically impossible. Good luck with the enterprise!

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