Choosing The Right Company Type

Founders often ask themselves “do I need to form a company to start a business? The answer is “no” but if you don’t set up a company, you will likely be subject to higher taxes and greater liabilities. Once you do decide to set up a company, there are a few company types to choose from.

“Once you do decide to set up a company, there are a few company types to choose from.” 

Once you have decided to set up a company (a wise move), there are a few company types to pick from:

• Sole Proprietorships. Generally speaking, a sole proprietorship requires no legal documentation, fees, or filings other than state and local business permits. On the other hand, there are disadvantages to operating in the form of a sole proprietorship: (1) it only has one owner and if additional capital is required from another investor, the form is not available and a partnership or other entity form is required and (2) a sole proprietorship provides no protection for the founder against creditors of the business (in other words, creditors can directly sue the founder), in contrast to corporations and LLCs where, generally speaking, the creditors of the business cannot successfully sue the founders and other investors. We don’t recommend sole proprietorships.
• General Partnerships. If there is more than one founder, a general partnership is often chosen as the legal form of business entity. Preferably, the founders will agree on a partnership agreement to “set the rules” among the founders; however, if the founders do not agree on a partnership agreement, most (if not all) state laws will supply the rules in the absence of an agreement. The income of a partnership is taxed directly to the partners generally on a pro rata basis. Finally, each partner of a partnership is generally liable for the debts of the business and thus exposes the personal assets of each partner to the business’ creditors. We don’t recommend forming a general partnership.
• C corporations. These are formed under state law (usually of the state where the business will be first operated or in a state such as Delaware that is known for its well developed corporate law). Most venture capital backed companies are C corporations.
• S corporations. These are formed under state law like C corporations but have favorable tax treatment for closely held (not more than 100 shareholders) corporations under federal and state tax laws.
• Limited Liability Companies (LLCs). These are formed under state law and are a hybrid form of corporation and limited partnership and have certain tax advantages over C corporations.
• Limited Partnerships. These are formed under state law and are often formed to hold investment real estate and also are often the “investment vehicle of choice” for private equity firms and hedge funds.

Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax, and accounting issues. However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital in contrast to sole proprietorships and partnerships.

Sole proprietorships and partnerships can later convert to a C or S corporation, LLC, or other legal entity but keep in mind that the conversion costs can be significant.

State of Formation

Once you have decided to form a company, you need to pick the state in which you will form it. Although forming a startup where its headquarters is located is generally fine, the most popular jurisdiction in which to form a startup is Delaware, primarily because

• Investors are most comfortable with investing in Delaware entities.
• Delaware has flexible business statutes.
• There is extensive business law precedent in Delaware.

Founders should also consider the costs associated with engaging a registered agent in a state of formation where the startup is not located and qualifying to do business in other states.