by Reza Rabiee
As Louisville’s strong entrepreneurial community continues to grow, this is a question more and more people will likely begin to face. Whether you’re participating in a startup accelerator program or simply working on a side-hustle while still employed in your full-time job, if you have developed an app or are starting any other business venture, you need to pay attention to some important issues that, if not addressed properly, could unravel all your hard work before your venture even gets off the ground. Remember that failing to plan often equates to planning to fail.
Entity formation, founders’ shares and tax considerations
One of the most common issues for entrepreneurs starting out is the question of when to establish a business entity and what type of entity best suits the needs of the business. While the procedural steps to set up a legal entity and obtain the appropriate tax identification numbers, etc., can be an annoyance, these are relatively straightforward tasks. The more important issues relate to other considerations, particularly with respect to issues of tax treatment, vesting of shares and governance.
Limited liability companies are generally taxed as partnerships, meaning that the company’s profits and losses are “passed through” directly to the interest holders, and the company itself is not subject to any taxation. Profits of corporations (more specifically, “C”-corporations), though, are subject to both an entity-level tax on profits as well as another tax at the shareholder level when dividends are paid.
Simple enough distinction, right? Well, that’s not quite the full picture.
In addition to the C-corporation, there is the S-corporation, which is also considered a pass-through entity, but comes with some specific requirements that, if breached, will negate its status. To add another wrinkle, LLCs can actually elect to be taxed as S-corporations, which could make sense, depending on, among other considerations, whether the interest holder(s) are also employees of the company (addressing the “self-employment” tax issue that might otherwise be imposed). In any event, the issues raised here only begin to scratch the surface of the decisions that must be made when initially structuring your business entity.
An important consideration among founders will be their respective percentage splits, number of shares issued to each, and the vesting schedule for those shares. By imposing a vesting requirement on shares issued among the founders, those individuals who contribute to the venture by remaining with it for the duration will be rewarded; and any departing founders won’t obtain an inequitable stake in the future success of the company.
Another decision implicated by share issuances is that of any individual shareholder to make an 83(b) tax election, which can help save substantially on a founder’s tax liability (depending on when the shares are issued and at what value). Again, the details of any particular situation will vary, but without careful consideration of such issues, you could be creating a disadvantageous situation for yourself without even realizing it.
Further, a commonly noted reason for establishing an entity is the “liability protection” that results from separating personal assets from those of the business. However, without understanding and properly complying with the formal governance requirements, that liability shield could potentially be pierced in court if you’re ever sued.
IP protection and considerations
In most technology and software startups, especially in the world of apps, the intellectual property IS the business. It goes without saying that protecting the business’s brand through trademark registration, and imposing negative rights on others against using or marketing your technology via patent registration, are of vital importance. Questions of timing, availability and use all impact the ability to protect your IP. If you want to learn more about intellectual property and how to protect it, see these other articles:
• More than a name: When and how a business should protect its brand
• What is intellectual property and why does it matter?
Funding your business
Sources for funding your business with the capital it needs to grow are varied and expanding: bootstrapping, conventional or SBA-backed loans, equity investors, crowdfunding, or any combination thereof. Understanding the pros and cons of each of these options will further your chance of success by developing a “capital stack” best suited to the needs of the venture.
While raising equity via angel investors or venture capital firms is often a major goal of many startups, it is not always most beneficial to the company or the founders. On that note, taking equity from the investor who gives your company the highest valuation can be a short-sighted approach, ignoring the multitude of ways VCs often take preferred and cumulative returns, as well as all of the intangible benefits of mentorship and guidance another potential investor could provide. Further, knowing whether you will eventually be seeking equity investment can also impact the entity selection question discussed earlier.
Beyond these more practical considerations, it is also important to remember that, even under the looser regulations promulgated under the JOBS Act, the disclosures required by state and federal securities laws (including any exemptions thereto) must be followed closely to avoid potential civil and even criminal liability.
Employee, supplier and customer agreements
Another important consideration will be whom to bring onboard to fill out your team. Should you hire employees or bring on independent contractors to fill the role? With that, you will need to ensure your engagement with any independent contractor is clearly defined so as to not be construed as an employer-employee relationship that could subject the business to various additional requirements. Thought must also be given to any nondisclosure, noncompetition or nonsolicitation agreements that may be needed to protect the business’s competitive advantage and customer lists.
Further, you will need standard terms and conditions to govern the use of your product which will need to be tailored to the specifics of the business. Additionally, you will likely need assistance in reviewing the terms of any agreements entered into with suppliers and vendors.
Be proactive in seeking legal advice
Be proactive about obtaining business and legal counsel on the above and other matters. The worst time to be seeking legal help is when confronted with a problem – at that point, it could be too late to resolve a disastrous situation that could have been avoided with proper planning. To quote Ben Franklin’s famous maxim: “An ounce of preparation is worth a pound of cure.” If you’re worried about the cost, remember that it will be much less expensive to pay for competent legal advice upfront to structure your business correctly than it will be to unwind poor planning, or worse, deal with costly and time-consuming litigation.
In seeking advice, though, remember these two caveats:
First, this is not a “set it and forget it” task. Don’t just delegate these decisions to a third party – be involved and work with advisors to explain your business objectives.
Second, don’t hire just any lawyer. Not all attorneys have experience with startups and the unique questions they face. Make sure any advisor you use has both real experience with the types of considerations discussed in this article and a true understanding of corporate law, business concepts, capital markets and, most importantly, your objectives as an entrepreneur.
You may have already considered some of these things, but even if this conversation is all news to you, don’t be daunted. View these decisions and the process of making them as an opportunity to enhance the likelihood of success for your business. If you’re serious about launching your venture, take the steps necessary to ensure its success – or, at the very least, not condemn it to failure by not planning properly.
View the article online at Insider Louisville.