Corporate Basics – Part I

• 1.6.2023
• Gary Schall, Daniel Zimmermann

This post is the first in a series looking at what founders should think about when getting ready to launch a company. Michaela Rosen was a co-author for this post.

Common questions founders ask when they begin to explore forming an entity are, when should I form a legal entity and what factors should I consider? In this blog post, we’ll explore when to form an entity, what types of legal entities to consider, where to incorporate and where to qualify to do business.

The Right Time to Form a Legal Entity

Once you are ready to move forward with your idea, you should form your startup as a legal entity. It is important to do this relatively early for a variety of reasons.

Liability: The right type of legal entity protects you from personal liability. This means, generally, that only the assets of the entity are at risk for actions of the entity, rather than your personal assets. While there are several types of legal entities, a corporation or a limited liability company (LLC) offers the greatest protection from personal liability compared to other legal structures like partnerships. Typically, a corporation or LLC limits the liability of the stockholders for a corporation or members for the LLC to the consideration they paid for their stock or LLC interest, respectively.

Intellectual Property: Everyone that contributes to the development of your business idea (that is, creates intellectual property) should assign all rights in the idea to the entity. The longer you wait to set up the entity, the greater the risk that one or more team members will not be willing to assign their rights in the idea to the entity, may no longer be involved with the startup and be difficult to locate, or may not cooperate in the future when you ask for the former team member to assign these rights to the entity. This creates a risk that investors will not invest in your entity because the entity does not have all rights to the idea.

Protect your Idea: When discussing your ideas with a third party, you will want the third party to sign a confidentiality agreement with your entity rather than with you personally.

Limited Liability Company (LLC) v. Corporation

As noted above, an LLC or a corporation provides the greatest protection against personal liability. Among an LLC, a Subchapter S corporation or a Subchapter C corporation, what's the best structure for you? Generally, the answer will be a Subchapter C corporation. For example, as your business grows you may compensate employees with incentive stock options, which cannot be granted in LLCs. The “Subchapter S” and “Subchapter C” descriptions identify the applicable section of the Internal Revenue Code that specify the tax rules that apply to those corporations.  However, from a corporate law perspective, a Subchapter S corporation is no different from a Subchapter C corporation. 

Outside Capital

Investors tend to look most favorably on Subchapter C corporations due to the limitations on Subchapter S corporations. Among other limitations, Subchapter S corporations cannot have (i) more than one class of stock or (ii) shareholders that are entities. During a venture capital financing, investors typically receive preferred stock (instead of common stock) and are legal entities themselves. Therefore, if the business seeks venture capital financing, investors will prefer a Subchapter C corporation, which is not subject to the limitations of a Subchapter S corporation. Likewise, there may be negative tax consequences to certain limited partners of venture capital funds that invest in LLCs. As a result, venture capital funds generally seek to avoid investing in LLCs.

Tax Treatment

Every dollar earned by a Subchapter C corporation is subject to tax at the corporate level. If the corporation then distributes that same dollar (net of the corporate tax) to the shareholders, it is subject to tax a second time at the shareholder level. This “double taxation” is a major cost to a  Subchapter C corporation that is generating revenue, earning income and making distributions to its shareholders.

In contrast, LLCs and Subchapter S corporations are referred to as “pass through entities” because entity level revenues - even if distributed to the members or shareholders, respectively - generally are taxed only one time at the member or shareholder level, as applicable. Similarly, the members of an LLC or shareholders of a Subchapter S corporation may be able to offset personal income from other sources against losses of the business depending on their involvement in the entity, thereby reducing their personal tax burden.

However, most startups do not face “double taxation” because they will not generate any revenue for some time. When a startup does generate revenue and earns income, that amount is typically reinvested back into the business rather than being distributed to the owners of the entity. Moreover, most founders of these types of startups devote their full-time to building the business, so they do not have other income that can be offset against the losses of the business.

Where to Incorporate

Most corporations are incorporated in Delaware due to the familiarity with Delaware corporate law from the parties involved in the business and Delaware’s company-friendly, well-defined laws.

For example, lawyers, directors, investors and future acquirers of your business have a solid understanding of the laws governing a Delaware corporation (the Delaware General Corporation Law) because most corporations are incorporated in Delaware. This makes all parties involved in the business more efficient and more comfortable doing business.

Additionally, the Delaware General Corporation Law is more flexible and company-friendly for corporations compared to other states and is updated annually to reflect current trends. For example, resolutions of the stockholders can be approved by a simple majority rather than unanimous consent. The Delaware Secretary of State also efficiently handles corporate matters, such as filing a Certificate of Incorporation or ordering a good standing certificate for a corporation.

Qualified to do Business

If your company is incorporated in one state (e.g., Delaware), but you are “doing business” in another (e.g., California, Massachusetts, New York, etc.), then the laws of the state in which you do business requires your company to be “qualified to do business” there.

“Doing business” is defined differently by the laws of each state. Most states provide guidance on the types of activities that do not constitute doing business, rather than what constitutes doing business. For example, accepting orders online, which could theoretically come from every state, is not enough activity to constitute “doing business.” In contrast, having an office or employees regularly and physically located in a state will often mean you will need to qualify to do business in that state. Most new corporations take steps to qualify to do business in the state where they are initially headquartered. For example, a Delaware corporation with its principal place of business in California would likely qualify to do business as a foreign corporation in California.

To qualify to do business in a state, you typically need to make a simple filing with the Secretary of State’s office that describes your business. You will also typically need to file reports and pay a fee (typically referred to as a “franchise tax”) in that state annually.