A Blueprint for Structural Design
By Gabor Garai
When you launch a company, the organizational structure you select –- corporation, limited liability corporation (LLC), partnership, sole proprietorship –- will likely feel like one of the more mundane decisions you make.
As a consequence, you may be tempted to decide on one of two grounds: tax reasons or limited liability considerations. But if you intend to seek out venture capital sometime in the first few years of your business launch, my advice is to pay close attention to your organizational moves.
From a VC's viewpoint, the process you go through when creating a company communicates important messages about your overall approach to business, and thus your likelihood of success. VCs know that when you incorporate, for example, you need to assemble a board of directors. They're impressed when you reject the temptation to, say, name your wife and children as directors, and instead include a mix of outside business experts and industry gurus.
Equally important, the initial organizational process requires you to set up business and financial record-keeping –- in effect, developing systems that set the stage for the company's expansion. You'll have to hire credible accountants –- not necessarily one of the "big guns" but a reputable regional firm with expertise in auditing emerging companies. And, of course, you'll have to hire a law firm with a focus on startups and venture capital, even if your brother-in-law is available for free.
VCs closely examine the organizational structure of investment candidates, and the message they take away from a company with carefully developed records is that this is a serious venture that recognizes the importance of having an appropriate infrastructure.
With all that said, what's the best structure? Generally speaking, the approach preferred by VCs is the simplest, most transparent one that addresses a company's key needs.
BETWEEN C AND S.
The desire for simplicity flies in the face of ideas by some entrepreneurs –- often fed by pals at the local country club –- to cobble together exotic off-shore partnerships in search of special tax benefits, or to create complex holding-company structures. In nearly all cases, these turn out to be a bad idea because they're expensive to set up and complicated and costly to maintain from legal, accounting, and administrative vantage points –- negating many of the tax benefits. Most important, VCs tend to be suspicious of such arrangements.
In the search for simplicity, a normal Delaware corporation tends to be the most comforting organizational vehicle, though LLCs are gaining in stature among VCs. They like the conventional corporate structure mainly because it's conventional –- it has been around for more than a century, and thus its rules have been well tested.
You've probably heard about C corporations and S corporations (or, as they used to be called, Subchapter S corporations). For all aspects of corporate law –- governance, shareholder rights, authority, corporate liability –- there's no difference. Only the IRS recognizes a distinction between a corporation that elects C status, which is a separate tax-paying entity, and one that elects S status, which is not.
Generally, the same corporate entity starts out as an S corporation for tax purposes, thus allowing its shareholders to recognize income or losses from the business to flow through to the individual owners. Once venture investors come into the picture, the S corporation will automatically become a C corporation because, under the tax laws, only individuals, and not institutions, can be members of an S corporation.
Increasingly, VCs are becoming more receptive to limited liability companies. The biggest advantage is that LLCs can be structured in the most flexible and creative ways to enable investors to get their money and tax benefits out in various priorities before the entrepreneurs.
For example, an investor group may require that it obtain twice its original investment plus 5% in annual interest and get most of the tax losses generated by the enterprise, before the founders are able to take anything out. On the other hand, LLCs are more complex (and thus more costly) to establish and to maintain day-to-day than some other options.
Among professional investors, angel groups are more tolerant of LLCs than venture capitalists are. Often the VCs and their own investors –- many of them pension funds and other institutions –- require that LLCs be converted into C corporations before investment is forthcoming. This isn't a complex matter if the LLC is structured in a straightforward way.
For entrepreneurs who are committed to organizing their businesses as LLCs, I advise resisting the temptation to include fancy bells and whistles that angel groups might request, such as special rights for different investors. Such complex structures are more difficult to convert later into C corporations, since the existing investors will need to approve the conversion and can potentially hold up a deal for an investment round from venture capitalists. And if they lose patience, such complexity can wind up killing a deal.
Gabor Garai (email@example.com) is a partner in the Boston office of national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies
Edited by Rod Kurtz