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Startup Entities: Choose Wisely, Founder, for Complexity Will Bring You Stress

Startup Entities: Choose Wisely, Founder, for Complexity Will Bring You Stress

When I first started my business in the fall of 2008, I was faced with a classic founders dilemma.  What type of entity should I incorporate, LLC, C-Corp, S-Corp?  There are hundreds and thousands of articles with mediocre advice regarding the various tradeoffs of these entities.  In this article I will share some real world experience with you creating my company 2008, and how our entity decision  impacted us much further down the line.  Before I go further, understand that I am not an attorney, and I am not licensed or qualified to give legal advice.  Please consult with your attorney before making decisions like this one.

On day one, I chose a Delaware limited liability company.  The incorporation was fast, inexpensive, and easy.  As the business grew, I brought on a partner to be my CEO.  We hired some of the best legal counsel in Silicon Valley, who quickly informed us that we would want to convert to a C-Corp to formalize our partnership and raise institutional money.  It was explained to us that this was the preferred entity type for institutional investors for a lot of different reasons, but chief among them was the tax structure of the various VC funds.  This was good advice, but I wish we had not followed it.

When we converted the LLC to a corporation, we promptly set about raising funds through a convertible note.  Once we had money in the company, we quickly got down and dirty with building our new business.   Ultimately we were acquired by another startup in 2011. This is where our choice of entity selection began to bite us.  Our acquirer wanted to purchase our assets and not our liabilities.  We entered into a purchase agreement where the acquirer gained our assets in exchange for preferred warrants.  That meant that our company would go on in perpetuity with no assets other than the warrants.

One of the purported advantages of C-Corps is that their shareholder rights and governance are defined by statue, where as member rights and governance of an LLC are defined by an explicit agreement between the members. The problem with a C-Corp comes when, for whatever reason, you are unable to afford legal counsel to advise you on the statutes in question.  Another problem is that C-Corps come with a lot of formalities with respect to keeping records,  board and shareholder meetings, and other governance issues.  These are all things that you need to stay on top regularly to ensure that your entity is in good standing and your liability is limited.  But what happens when the music stops?

Now we had our C-Corp with no employees, no cash, and with no purpose except to serve as the holder of those preferred warrants for ourselves and our investors.   We ended up making a subchapter S election to give pass-through treatment of our profits and losses. The accounting required for such subchapter S-Corps has many more complicated than that of an LLC.  And, for two years we had to keep going right along with shareholder meetings, keeping minutes, and making resolutions.  For two more years, I had to keep filing corporate tax returns, and keeping the entity in good standing with the State on the chance that we might need to liquidate the warrants and distribute the proceeds.  Fortunately our acquirer was also acquired within two years.  But what if I had to keep going with that process indefinitely?

What a nightmare.

In hindsight, we would have been much better off by keeping the LLC structure and amending our operating agreement as needed.  The LLC afforded us a very simple and flexible structure, one that was easy to understand, and one that was very cheap to maintain.  The costs and formalities for maintaining and governing LLCs are extremely limited.  We could have delayed the C-Corp conversion to the point where we had a committed institutional investor who was demanding it.  Or we might have been able to make an IRS election to be treated as s a corporation.

We went through the whole entity lifecycle, from LLC, to C-Corp, to subchapter S-Corp with one and the same business.  In other words, we ended up back where we started, but with a lot of added complexity and expense.  Seven years later investors and their counsels seem much more comfortable with the LLC entity. There are plenty of good boilerplate agreements you can modify suit your needs.

For this founder, the next entity decision will be easy.