A business typically exists as soon as the person engaging in the activity says it does. The label business is simply a statement about intent: if you intend an activity to make money by providing goods or services to customers, congratulations, that activity is a business.
A company, on the other hand, is a particular operating structure registered in some jurisdiction. They come with substantial rights and responsibilities.
Many entrepreneurs wonder whether their businesses should become companies (via a process called “incorporation”) and, if so, when, and what form of company? We’ve written a quick guide to explain this.
What is the alternative to incorporation?
By default, a business has no existence apart from its owners. This is called a sole proprietorship (sometimes called a sole trader outside of the U.S.) if it has only one owner or a partnership if it has multiple owners.
Sole proprietorships are extremely common; the Internal Revenue Service (the U.S. taxation agency) is aware of approximately 27 million of these informally organized businesses (compared to approximately 6 million formally incorporated businesses.) This is broadly true across most countries which have a distinction between sole proprietors and corporations.
So why incorporate if 80%+ of entrepreneurs do not? To quote the Orrick Legal Guide for Stripe Atlas:
The primary reasons for selecting a corporate form is for the limited liability and perpetual existence that these organizations can provide because once a company is formed, it is regarded as a separate legal entity from its owners. Sole proprietors and partnerships are usually personally liable for the debts and obligations of their businesses and the businesses cease upon the death or departure of the principals.
Incorporation is primarily about risk reduction for all parties in an enterprise.
- Incorporation clarifies the ownership interests of entrepreneurs, investors, and employees, allowing everyone to be confident that they are receiving the deal which they believed they bargained their money/labor for
- Incorporation moves liability for debts and obligations of the business from the entrepreneurs into the company itself – since the law recognizes it as a separate entity from its owners
- Incorporation turns a business from a concept into a thing; that thing can be owned, bought, sold, borrowed against, destroyed, etc., like any other property
- Incorporation sends a signal to customers, partners, and the rest of the world that the business intends to operate in a professional manner
The chief reason many entrepreneurs choose to not incorporate is that running a real business is complicated and expensive. A sole proprietorship exists as soon as you say it does. It can stop existing almost as quickly. A company, on the other hand, is like a puppy: owning it obligates you to expensive upkeep, even when you are tired of it chewing on the furniture.
When to incorporate?
Whether to incorporate one’s business or not is a decision to make carefully after talking to one’s professional advisors, such as a lawyer or accountant. Some factors which typically counsel incorporation are:
Incorporate immediately if you’re told to by professional advisors
Some businesses are, by their nature, so exposed to liability that they should almost always be operated as an incorporated entity. Your lawyer and/or accountant can, given a brief description of your business, likely give you their considered opinion on whether your industry or business model strongly warrants incorporation.
Your lawyer or accountant might also advise incorporation as a proactive measure if you have substantial assets outside of the business, such as e.g. other business interests or a house, which should be protected from debts/liabilities attached to the business.
Incorporate if you want to share ownership with anyone else
Unincorporated partnerships can exist. That said, they have some drawbacks compared with incorporated partnership structures, like limited liability companies (LLCs). Most entrepreneurs with partners choose to have an LLC or corporation.
Partnerships are extraordinarily customizable with regards to who is contributing what and who ends up owning what as a result of the partnership. This customizability can be extremely complicated, and making sure the agreement is fair to all parties (and appropriately de-risked) can run up a large tab for professional services. It is possible you can economize on costs and complexity by adopting a variant of an LLC or corporation.
An unfortunate fact of starting businesses is every relationship will eventually come to an end. LLCs and corporations have well-established mechanisms for removing a partner or winding down entirely. Ad-hoc partnerships often don’t, adding additional headaches, expense, and legal risk to an outcome which is likely already an unhappy one for all involved. You can avoid heartache during the dissolution of your ad-hoc partnership by formalizing the partnership early.
The legal name for an ownership interest in a company is equity. There exist a variety of ways to grant it. These implicate an existing legal infrastructure which dates back hundreds of years. Holders of equity have predictable rights which they can reasonably assume will be enforced; this is part of what makes equity in a successful business so valuable.
Most founders who want to share ownership of a business with employees or advisors (even if they’re not full partners), choose to grant equity—via a well-defined instrument—in an entity rather than having poorly specified, informal agreements that come back to bite you later.
Incorporate when you anticipate taking investment
Sophisticated investors want to know that, in return for their investment, they will share in the economic proceeds of the business as agreed. This is much easier to guarantee for corporate entities than for unincorporated businesses; we have centuries of practice in accounting for how much money companies make, apportioning varying amounts of control over their operations, and handling disputes in interpretation regarding agreements made about them.
Most serious investors prefer to invest in a corporate entity rather than an unincorporated entity. The exact timing of incorporation depends on the particular deal and investor; sometimes the deal is struck in principle before incorporation and formalized with the newly-incorporated company, usually the company being formed is a prerequisite to having the deal.
Incorporate before hiring a full-time employee
There are many, many ways that businesses are regulated. One of the most detailed and complicated ways is in their interactions with employees, due to the social importance of the employment relationship. Accordingly, bringing on your first employee causes a quantum leap in the level of sophistication that you have to bring to running your business and to the potential downside risk of being non-compliant.
Additionally, your business may be responsible in some circumstances for that employee’s actions. If you have not incorporated, the business does not have a separate identity than you personally, so you personally might be forced to pay for their mistakes.
Incorporate as your business approaches material size or complexity
As businesses grow, they tend to get more complicated and to accrete more sources of risk. You’re shipping more products to more customers. Your services start getting sold to more sophisticated customers, who have more to lose if you break things and more propensity to sue when things get broken. You attract the attention of bad actors.
Incorporation can help limit your personal exposure to risks which that might properly belong to the business you’re running.
What “material size” means to you is a great question to run by your accountant, but as a guideline, in the United States, many businesses with revenue above $100,000 choose to incorporate.
What types of companies are there?
Companies, in the United States, are regulated at the state level, not at the federal (national government) level. The laws of the 50 states generally provide for limited liability companies (LLCs), corporations (generally referred to as “C corps”), and a few more exotic options which are not relevant to most people running internet companies.
Should I have a C corporation?
Most companies that seek to raise investment from investors in the United States choose to have a C corporation, specifically, a Delaware C corporation. It is the overwhelming choice of technology companies and their investors—over 90% of IPOs in the US from 2007 through 2014 were of Delaware C corporations (see here, page 8). If you have another type of entity, your investors may ask you to dissolve it or convert it into a Delaware C corporation as a condition of, or pre-requisite to, investing, which can be needlessly costly.
Why do venture capital investors overwhelmingly prefer to invest in Delaware C corporations? Quoting the Orrick Legal Guide for Stripe Atlas:
Forming your company in Delaware is easiest and most efficient. Delaware is the state of incorporation for more than 60% of Fortune 500 companies. Delaware has an established body of laws governing corporations: it’s the only state to have a separate business court system (the Court of Chancery). This is meaningful to entrepreneurs for two reasons. First, there is a long-established body of laws relevant to corporations that has been tested in the Delaware courts over many years. In the event of any legal action, therefore, there is a high degree of predictability. Second, Delaware has a long record of pro-management decisions. Venture capitalists (VCs) feel more at ease when they see that a company is incorporated in Delaware because it is familiar to them.
Should I have an LLC?
LLCs have a few advantages over C corporations:
- They cost less to incorporate
- They’re generally easier to incorporate and administer in an ongoing fashion
- They offer pass-through taxation, which may be more tax efficient in some circumstances, particularly for smaller firms
Many solo entrepreneurs, consultants, or folks doing freelance work choose LLCs for these reasons. It is far less common to see high-growth technology companies choose to organize as LLCs—those companies usually choose to take investment at some point, at which point they typically will be forced by investors to become C corporations.
Is one type of corporation more a “real business” than the other?
This is an excellent question for many of our international entrepreneurs, since in some countries some classes of corporation are treated as second-class corporate citizens. This is not widely true in the United States. Companies are happy to deal with both C corporations and LLCs. Individual consumers largely do not particularly understand the difference. Both are well-understood, supported options for interacting with the government.
I’ve heard of S corporations?
An S corporation is not a separate type of company. It is a particular way to elect (ask the IRS for) the pass-through tax treatment of LLCs with the corporate form of a C corporation. The IRS covers the topic in more detail here. We’ll cover S corporations in more detail at a later date.
Who can incorporate companies?
Substantially anyone can incorporate a U.S. company and own all of its equity interests. You do not have to be a U.S. resident or U.S. citizen. A foreign company can incorporate and wholly-own a U.S. company. Misconceptions about this are common, but the Orrick Legal Guide for Stripe Atlas is clear:
There are no U.S. federal or state laws that require a stockholder or LLC member to be a U.S. citizen or permanent resident to form a U.S. company. Non-U.S. nationals can own all of the shares of a U.S. corporation or be the sole members of a U.S. LLC. Nor must a member of the corporation’s Board of Directors or corporate officers own any shares (like “directors’ qualifying shares”). Similarly, all of the members of the U.S. corporation’s Board of Directors and all of its officers can, if so desired, be non-U.S. nationals and U.S. non-residents.
There exist millions of U.S. corporations which are directly controlled by people outside the United States, including many people/corporations who are not U.S. citizens. This is considered a normal business practice—the United States does an incredible amount of business internationally, which requires foreigners to be able to transact business in the United States, and when they do so it is often most convenient for them to transact as U.S. entities. People routinely incorporate U.S. companies for projects as simple as owning a flat or a condominium.
Corporations owned by foreign residents or non-citizens are still corporations.Volver a las guías