When a client comes in for an entity formation matter, the first thing we need to decide is whether the client should form a LLC or a corporation (there are, of course, other business forms such as sole proprietorships, joint ventures, partnerships, and business trusts, but they are generally unsuitable for startups, particularly high-growth startups). To answer this question, the client and I discuss the client’s needs and interests and the timeline and goals for the business, which generally points us to the more ideal choice. The following are some of the factors that I look for — as a disclaimer, I should also point out that this is by no means an exhaustive list or a definitive analysis for your business, as every business is different, and you should consult legal counsel on your own particular situation.
LLCs are a new form of business entity whose primary feature is that they inherently flexible in their construction and can be run very informally — you can design a LLC to operate however you want. But with that newness and flexibility also comes a bit of ambiguity, as there are significant legal questions surrounding LLCs that have yet to be answered by state courts. It is this uncertainty I think gives investors pause when considering an investment in a LLC (and often leads them to asking the founders to change to the corporate form).
Corporations, on the other hand, are more formalistic and well-understood, but there can be more administrative paperwork in running them (particularly when it comes to taxes). But that formality and certainty can make corporations easier to form for larger groups of founders, and makes investors feel a little bit better about running them.
As a result, I generally tend to recommend corporations for startups that have a high-growth strategy, particularly in the near-term, will be seeking investment from angels and VCs, and will likely need a tiered equity structure for such investors as well as for employee compensation. On the other hand, for one-person or small teams of entrepreneurs who are pursuing smaller companies or a brick-and-mortar strategy, are self-funding or at the most seeking friends-and-family investment, and aren’t looking to give equity to employees, LLCs may have advantages over the corporate form, and such cases I sometimes recommend it as an option.
NOTE: The First Venture Legal Blog is going on holiday break; look out for our next article on Friday, January 4, 2013. I would like to wish you all a happy holiday season and a happy new year, and I look forward to having you all back here again in 2013!