Why and When to Form a Company
Starting a business can be exciting, but there’s one critical step to take early on—forming a legal entity. Although incorporation might seem like a procedural step that can wait, early entity formation prevents complications that become increasingly difficult to resolve as your business grows.
Here are the key considerations:
- Limited Liability Protection. This is the most important reason to set up a formal entity like a corporation or a limited liability company (LLC). Without this protection, a contract dispute or customer claim could put your personal savings, home, and other assets at risk. A proper entity structure creates a legal barrier between your business obligations and personal assets.
- Access to Investment and Loans. If you plan on raising money through investors or taking out a business loan, forming an entity is typically a must. Banks and investors require a clear separation between personal and business finances before offering capital. Delaying proper entity formation often creates unexpected obstacles during critical fundraising periods.
- Perception and Credibility. Incorporating your business sends a strong signal to clients, partners, and investors that you’re serious. Most businesses, especially those aiming for growth, go beyond the one-person operation and establish an LLC or corporation early on. This structure often leads to more favorable contract terms and stronger business relationships.
Which Entity to Form
While various legal entities exist, most businesses choose between C-corporations and pass-through entities, such as limited liability companies (LLCs) and S-corps. Each type establishes the business as a separate legal entity, providing a “corporate shield” to protect your personal assets. They differ in taxation, management requirements, and ownership flexibility. Your choice should align with your business model, growth strategy, and funding objectives.
C-Corporation (C-Corp)
Pros
• Investment Potential: C-corps provide the preferred structure for venture capital and angel investors. Most institutional investors’ fund documents explicitly prohibit investing in other entity types, making C-corps mandatory for ventures seeking institutional capital.
• Stock Options & Equity Incentives: C-corps offer standardized mechanisms for equity compensation, following well-established patterns that simplify talent acquisition and retention. This standardization proves particularly valuable when competing for top talent against larger companies.
• Qualified Small Business Stock (QSBS): C-corps exclusively offer potential tax advantages through the QSBS exclusion, allowing founders and investors to potentially exclude a substantial portion of capital gains from stock sales. This benefit can significantly impact wealth creation during an exit.
Cons
• Double Taxation: Corporate profits face taxation at both the corporate level and when distributed as dividends. However, this impact remains minimal for high-growth companies reinvesting profits rather than making distributions.
• Administrative Burden: C-corps require structured governance, including regular board and shareholder meetings.
Pass-Through Entities: LLCs and S-Corps
For service businesses or companies not pursuing venture funding, LLCs and S-corps often provide better options. These structures pass profits and losses directly to owners’ personal tax returns. While S-corps offer attractive tax benefits, they come with significant ownership restrictions affecting shareholder eligibility, number of shareholders, and stock classes, which can create unexpected obstacles during growth phases.
Pros
• Pass-Through Taxation: Business profits flow directly to personal tax returns, avoiding corporate-level taxation. This structure particularly benefits profitable businesses making regular distributions.
• Simplicity: These entities, particularly LLCs, require less administrative overhead than C-corps, making them well-suited for smaller or service-based businesses with straightforward operations.
Cons
• Investment Limitations: While these entities can attract outside investment, institutional venture capital rarely flows to pass-through entities. Converting to a C-corp later may trigger complex tax consequences depending on how the business was capitalized.
• No QSBS Exclusion: Pass-through entities cannot qualify for QSBS treatment, potentially limiting tax advantages during exit events.
• Unforeseen Tax Risks: ⚠️ Pass-through entities face complex tax implications when using startup funding instruments like convertible notes or SAFEs. These complications frequently emerge during financing rounds and require careful planning to avoid adverse tax consequences.
Sole Proprietorship (and General Partnership Risks)
Operating without a formal entity leaves no distinction between business and personal assets. Despite its apparent simplicity, this approach creates unacceptable risks for most business owners. Every business obligation becomes a personal liability, and mixing personal and business assets severely limits access to outside investment.
The risk multiplies with multiple owners. Without a formal entity, courts may deem the relationship a general partnership, making each partner personally liable for others’ business decisions. This arrangement creates untenable risk for most business relationships.
Making Your Choice
Your entity structure fundamentally shapes your business’s future. C-Corporations provide the standard structure for venture capital investment and offer valuable benefits like QSBS treatment and standardized procedures for implementing an equity incentive plan. LLCs and S-Corps better serve service-based businesses through tax advantages and simpler administration, though they limit certain funding options. Regardless of choice, establishing a formal entity protects your personal assets in ways that sole proprietorships and general partnerships cannot.
Navigating entity formation is critical for long-term success. As a law firm for startup companies, Braverman Law PC provides experienced legal services that can help you decide how to incorporate your business. Contact Braverman Law, today.
Quick Reference: Key Terms
• SAFE (Simple Agreement for Future Equity): A startup investment instrument that provides rights to future equity, typically converting during a priced round. Often used by early-stage companies as a simpler alternative to convertible notes.
• Convertible Note: A debt instrument that converts to equity under specified conditions. Unlike SAFEs, convertible notes accrue interest and have a maturity date, making them more complex but potentially more protective of investors.
• QSBS (Qualified Small Business Stock): Special tax treatment under IRC Section 1202 allowing potential exclusion of capital gains from the sale of qualifying C-corporation stock. Can provide significant tax savings during an exit.
• S-Corporation: A special tax status allowing corporations to be taxed as pass-through entities while maintaining corporate liability protection. Subject to significant ownership restrictions that can limit growth options.
