I wrote this article for the Business to Business Issue of Style Magazine in June. I hope it helps…
So You Wanna Start a Business?
© Kevin E. Houchin 2007
Not long ago, if you wanted to go into business with someone and not lose your house if your associates made a bone-headed move, you had to form a corporation. Today you have options, but options don’t necessarily make decisions easier. Just think about the menus at different restaurants, options are great, but they can be confusing and sometimes overwhelming. Forming a business can be the same way, but if you follow these steps, life will be a lot easier. I’m not going to be able to go through ALL the variables in the space of this article, so think of this article as the “daily special” menu at your favorite lunch joint, and be sure to ask your server (that would be your lawyer) about how to modify the dish to your particular taste.
Here we go: Default Position = LLC
Forming a Limited Liability Company (LLC) is always my default position for new companies. The reasons for this position are that:
1. As the name says, you limit your personal liability to the investment you’ve made in the business. In other words, if your associates or employees mess up and end up bankrupting the business, you won’t lose your house. Of course, if YOU mess up, for instance you have a car accident on company business, you’re still liable to lose your personal (non business) assets, but this is true no matter what form of business you create. So, one of the biggest reasons to incorporate historically, has now been equaled in an easier, more flexible business form.
2. Forming an LLC is relatively easy. It only costs $25 to file with the Colorado Secretary of State and it can be done online in about 15 minutes, assuming you do not have more than a handful of initial “members” (owners of the LLC).
3. You can operate the business relatively informally, like a partnership, and save a bunch of organizational overhead–which translates into more time to run your company, and less time in the lawyer’s office creating necessary paper work.
4. You have flexibility to creatively allocate profits and losses between the members. For instance, if one of the initial investors is really looking for some losses to offset other income and lower her tax bill, an LLC offers that flexibility.
5. Finally, an LLC is a “pass-through” entity for tax purposes, meaning that the income or loss from the business operations isn’t taxed at the business level, and then again at the individual level (as in a standard corporation), thus avoiding “double-taxation.”
One important thing to remember is that if you have “members” (owners) of an LLC that you’re not married to, it’s VERY important to create an “Operating Agreement.” Think of forming a business with someone else as a marriage, and the Operating Agreement of an LLC, or the By-Laws of a corporation, as the pre-nuptial agreement. It’s best to figure out what happens when you split up or sell out while everyone is still in love with the idea of hooking up. Crafting the Operating Agreement is one of the key reasons to hire a lawyer.
LLCs are OWNED and usually MANAGED by the “members” as would happen in a partnership, without a Board of Directors getting in the middle. The Operating Agreement spells out how this works, and most importantly, how ownership interests in the company change hands–voluntarily or otherwise.
So, why would you even consider forming a corporation? The easy answer is that corporate “shares” are generally easier to buy and sell then membership in an LLC. So, if you plan to bring in outside investors, it’s best to get started as a corporation right off the bat. The start-up costs are going to be about the same, but you’ll save time, headaches, and money down the road.
Initially you’ll probably want to form a “Subchapter S Corporation” or “S-Corp” for short. This classification is based on Section 1361(b) of the Federal Tax code and limits the pass-through eligibility to corporations with 75 or fewer shareholders, prohibits more than one class of stock, and limits permissible shareholders to individuals, estates and certain types of trusts and tax-exempt organizations. It also prohibits any nonresident alien shareholders. A lot of companies start out as S-Corporations, and then drop the status and become “normal,” “C-Corporations” as they grow.
Venture capitalists are used to working with C-Corporations, so if venture investment is key to your plan, get used to the idea of “corporate formalities,” because they’ll be part of your life.
One of those formalities is that a corporation is OWNED by the shareholders, but MANAGED by a Board of Directors. There are many rules here, generally to protect the shareholders and make sure the Board of Directors is acting in the best interests of the shareholders, rather than in the best interests of themselves (as in the case of Enron, WorldCom, and the other scandals). If you only have a handful of owners, and they all work in the business, this level of formality is probably overkill. If you’re planning to take the company public, and will probably need several rounds of capital investment, this level of formality is very necessary.
If you decide to form a corporation, you will need to draft “by-laws” instead of and “operating agreement.” You will actually issue “shares.” If you’re not concerned about S-Corporation taxation, then you might actually issue several “classes” of shares that can be complex, or relatively simple. You will need to elect a Board of Directors including a President, Secretary, and Treasurer. You’ll need to document your meetings formally and keep a record book of Board meetings.
In summary, the first goal of business formation is to limit liability, which is accomplished through either LLC or Corporate form. The next consideration is taxation; you want to get the pass-through status if you can qualify to avoid “double-taxation.” After that, things get a little more complex and reflect your short and long-term capital needs. Working through these complexities is why you pay an attorney.
Kevin E. Houchin is principal of Houchin & Associates, PLLC – a copyright, trademark, arts & entertainment, business development, and branding firm located in Fort Collins, Colorado. To contact Kevin, call 970-493-1070, visit www.guidingvalue.com or email email@example.com.