If you’re thinking about starting your own business, you must be mindful of the costs of starting up a business. The first category of costs are the incorporation and licensing costs. Most startups are formed as either corporations or LLCs, both of which carry filing fees in order to register with the state. startups who are looking to raise private capital typically incorporate in states such as Delaware or Nevada, even though those companies will not be located in those states — this means that those founders will have to pay more filing fees to register their Delaware or Nevada corporation/LLC to do business in their state of residence. Of course, the benefits of incorporating/organizing in Delaware or Nevada can outweigh the additional costs. Even if you plan to operate as a sole proprietorship, unless you are going to operate under your own name, you will need to file a DBA with the city or town where your business will be located. Furthermore, depending on the line of business you are entering, you may also be required to obtain licenses from the state or municipality in order to do business. Filing fees vary from state to state, and vary with the form of business; corporation filing fees can even vary depending on the number of shares the corporation is to have. While some state filing fees can be as low as $60-$80, they can reach into the thousands for corporations with millions of authorized shares. Another expense many startups have, relating to incorporation/organization, is the registered agent. The registered agent is the entity that is appointed to accept service of process and other legal documents on behalf of a company. Corporations and LLCs must have registered agents in every state where they are registered to do business. Therefore, while founders may be able to act as registered agents in the state where they live, for those companies that incorporate in Delaware or Nevada, hiring a company to act as a registered agent is all but a necessity. Registered agents will likely cost you between $75-$150 per year as a base; if you need additional services such as forwarding of served documents, filing of annual reports, etc., the costs obviously go up into the hundreds of dollars. The one startup costs that entrepreneurs attempt to avoid most of all are the legal and accounting fees. Although a solo founder may not need complicated corporate governance documents, they are critical for multi-founder teams. It is important to establish how the business is to be run and the rights and obligations of the founders from the get-go, rather than trying to figure it out when an issue arises; it becomes harder to sort it out when founders become adversarial over a contentious issue. CPAs are also critical for businesses, as the taxes for any business can quickly become incredibly complex and difficult to manage. Of course, entrepreneurs are less than willing to pay for legal and tax/accounting advice because costs will be in the thousands of dollars. But the costs of bringing in lawyers and accountants to fix a problem that could have been prevented in the beginning will be far, far more. Companies also need websites and social media presences. Websites, at a minimum, have hosting costs that can be as low as $50 depending on the company and how much server space and bandwidth is needed. A startup can certainly build its own website; outsourcing it to a developer will probably start at around $500, with the price rising to the thousands the more dynamic/feature heavy the website needs to be. Startups can also manage their own social media presences (Twitter/Facebook/Instagram accounts), while outsourcing it to a media company will cost hundreds or thousands of dollars a year. Finally, startups may also have office or other brick & mortar costs. Although a web or app company can run out of a garage or dorm, there are affordable office options in the form of virtual office and co-working spaces, many of which are focused on startups. For just a few hundred dollars per month, companies can get access to office space in virtual offices and co-working spaces, most of which come with great amenities such as printing, food and beverage, game rooms, social events, etc. Of course, direct-to-consumer, retail companies and the like will likely need brick & mortar space, which carries rent, utilities, insurance, and other costs, which can easily reach into the thousands of dollars per month.
The question of which state an entrepreneur should incorporate or organize his or her business in is an important, if sometimes overlooked, question. Some startup founders simply choose the state in which they live; others choose Delaware without considering why Delaware is a preferable choice and whether the benefits of Delaware are even applicable to one’s business.There are a number of factors founders should consider when deciding what state to incorporate in. Cost Chief among the considerations is cost. Each state has different filing fees for corporations or LLCs. Corporate filing fees are typically based on the number of authorized shares, with a minimum filing fee that authorizes up to a certain number of shares; for example, the minimum filing fee in Delaware is $89, which authorizes up to 1500 shares, whereas the minimum filing fee in Massachusetts is $275 which authorizes up to 275,000 shares. More authorized shares means a higher filing fee. Companies also generally have to pay annual fees to maintain the business’ incorporation/registration. This fee is usually connected to the filing of an annual report, or may be considered “franchise tax”. These fees also vary from state to state. When a company organizes in a hub state such as Delaware while being located in another state, they face the prospect of doubling these fees. Although there are opposing schools of thought, I recommend to clients, whose founders live and will work in Massachusetts, who incorporate in Delaware to register their Delaware corporation to do business in Massachusetts. This requires not only paying Delaware filing and annual fees, but also Massachusetts filing and annual fees. Incorporating in Delaware while being located in another state also requires companies to retain companies to serve as their registered agent in Delaware (the registered agent is the person or entity that accepts legal documents on behalf of the company, and must be physically located in a company’s home state and the states where it is authorized to do business) Laws Another factor to consider, one that tends to weigh heavily in favor of Delaware, is the state’s corporate and business laws. Does the state where you want to form your company legally permit you to structure your company the way you want? If not, you’ll either have to change how you structure the company, or pick another state to organize it in. Delaware is generally considered to have the most modern and flexible corporate laws of any state. Unlike many states, the Delaware legislature regularly updates the business laws to reflect the evolving needs of businesses. For example, last year Delaware added a provision to its corporations law allowing corporate boards to ratify defective past corporate acts as if they were validly undertaken, so that companies don’t have to worry about past defective acts potentially scuttling business deals and operations. Why Delaware? Delaware is one of the most popular states to incorporate or organize a business in due in large part to its modern and flexible laws. In addition, Delaware has a separate court, the Court of Chancery, dedicated exclusively to hearing corporate law disputes; cases are decided by judges who are experts in corporate law, rather than lay juries, and are resolved in weeks rather than the months or years other state trial courts take. With modern statutes and well-developed case law, Delaware corporate law is considered the “gold standard” that every corporate attorney learns and understands, so that lawyers representing clients from all over the country have a common frame of reference. For these reasons, many venture capital and private equity firms require that the companies they invest in be incorporated in Delaware. So Where Should I Incorporate/Organize? My general rule of thumb is if a company plans on seeking private investment within one to two years, they are best served by incorporating or organizing in Delaware — although not every investor requires it, there are those who do, and the ones who don’t require it won’t mind if you are organized in Delaware. It also makes sense to avoid the hassle and expense of reincorporating in Delaware from another state if an investor insists upon it. If a startup has no intention of seeking private investment, or private investment is more of a distant possibility, then it makes more sense in the short-term to simply incorporate or organize in the state where the founders are located. That way, the company does not end up paying double filing/annual fees to form the company — and for most startups, every penny counts.
Many founders wonder when they need to plan out how much of the equity will be made available to compensate the key employees of the company — this is the process of creating or setting aside an “option pool”. The best time to do this is at the beginning of the company, when it is being formed and when the initial equity is being dealt out to founders (and potentially investors). There are a couple of reasons why setting up the option pool as soon as possible is critical. First, you will want to make sure that there is sufficient stock to be able to provide equity to all the employees who will receive equity. This dovetails into the second issue, which is the concern that investors will have of being diluted. If investors know the size of the option pool, then deals can be adequately structured to avoid or minimize the dilution of private investors. Otherwise, companies run the risk of measurably diluting their investors if an employee equity pool has to be created or expanded to accommodate additional equity for employees.
We’ve seen famous cases of successful startups who’ve become big companies have issues involving former co-founders or collaborators who left or are ousted from the company in the early stages wanting to be compensated for their often-critical contributions to the company’s product or service — the issue arises when the company didn’t have proper agreements in place to govern the relationship between the founders. These agreements can take different forms depending on the legal structure of a company — whether the document is a simple “founders’ agreement” when the startup is unincorporated/non-organized, a shareholders’ agreement when the company is a corporation, or an operating agreement if the company is a LLC. However a startup is organized, and whatever form or name a document takes, the founders of any startup should have an agreement in place spelling out their rights and responsibilities to one another and to the startup, which should minimize disputes in the event things go wrong in the founder relationship. There are a number of terms and provisions that should be included in your agreement with your co-founders. Among these terms and provisions are: – Co-founder roles and responsibilities: What role is each founder going to take; what are their responsibilities and their deliverables? – Equity split and vesting: Obviously equity will need to be split when the company is legally formed, but the split can also be decided upon in an agreement made before company formation. Additionally, vesting can be decided upon when the equity split is made, based on time spent with the company, goals or deliverables met, etc. – Co-founder exit and removal, and contingencies for disability and death: Importantly, what is the process by which a co-founder can be removed, and what is a co-founder entitled to if he or she is removed, or voluntarily resigns from the startup? Also, what is the procedure in the event of an emergency that renders a co-founder temporarily or permanently unable to work on the company? – Capital and other contributions: What is each co-founder contributing? – IP assignments: Co-founders should be assigning the IP related to their work for the startup to the company — many conflicts arise because a departed co-founder asserts an interest in the IP being used by the startup. – Management and voting: How are both day-to-day and important strategic decisions being made? The earlier these types of agreements are completed, the better — not only can more issues be resolved at an earlier stage, but it is better to decide how potential issues are to be resolved when the co-founders still (presumably) have an amicable relationship. Ideally, you and your co-founders should be consulting with a business or corporate attorney, who can advise you on different or additional terms that your particular team and startup may need in its agreements, and can help you and your fellow co-founders work through the decision-making process in deciding the precise terms of your agreement.
I’ve had many clients and prospective clients ask me to break down the differences and pros and cons of a LLC versus a S-Corp. The difficulty with answering the question is that the question is asking for structural differences, but when referring to a S-Corp, one is referring to a tax classification.
A S-Corp is a qualifying corporation that is taxed under Subchapter S of the Internal Revenue Code. Subchapter S is a form of taxation known as “pass-through” taxation, in that the profits and losses of the company are “passed through” to the shareholders, who are then responsible for reporting their share of those profits and losses on their own tax returns and paying the appropriate share of taxes, regardless of whether or not any money is actually distributed from the company to the shareholders.
You’re now probably wondering what a C-Corp is. C-Corps are taxed under Subchapter C. It is the default classification for new corporations, and is known as “double taxation”. The corporation pays taxes on its income; the shareholder pays the tax on any dividends paid to them at the dividend rate. So if a C-Corp makes $100,000 in taxable income, it pays the tax on that income; then if it pays $1000 dividends to its shareholders, the shareholders then pay taxes on that $1000 — hence the “double taxation” moniker.
LLCs can also elect corporate taxation (assuming they qualify) under Subchapter C or S (by default, single-member LLCs are disregarded for federal [and sometimes state] taxes, multi-member LLCs are taxed as partnerships). Therefore, when discussing the entity structure, the better question is not LLC versus S-Corp or C-Corp, but LLC versus corporation (which should also include a discussion about the state where the company is to be formed). Once the entity form has been decided, then the tax classification of the company can be discussed.