Partnerships, LLCs, Corporations: What’s best for your business?
Laura Norris, Associate Clinical Professor and Director, Entrepreneurs' Law Clinic
I’ll spend the next few minutes talking about the different forms that businesses can take, and which might be right for you. Keep in mind that I’m providing you with general information, and this should not replace advice from a lawyer and a tax advisor.
You may not have realized it, but if you are working on a business idea right now, you are already considered a sole proprietorship or partnership. If one person works alone on a company, that is a “sole proprietorship.” If two or more people work together on a company, that is a “Partnership.” Both of these forms expose the owners to personal liability, meaning if your company owes money to someone, you are on the hook. This is obviously not ideal. However, in very early stages of your company, this might be acceptable. You may not need to rush into creating a different type of business because you are not yet creating liabilities. If you do decide to remain a partnership for some time, you should enter into an agreement with your cofounders to avoid disputes down the road. If your company is incurring potential liabilities, by releasing a product, hiring employees, or signing contracts, then you should create a limited liability business. The two common choices are either a Limited Liability Company, or LLC, or a corporation. A corporation is a good choice for a company that is going to get venture capital financing or wants to set up an employee stock option plan. But an LLC is easier to maintain, more flexible than a corporation, and can be converted to a corporation easily. It may make sense to form an LLC first and convert it to a corporation later.
To illustrate, let me tell you about a company I worked with a few years ago. It was an internet startup founded by 4 college roommates. While they were in early stages of developing their product idea and writing their business plan, they signed a founder agreement to set out expectations and ownership share. When it came time to take investment from friends and family, they set up an LLC and gave shares of the LLC to the investors. A year later, they got a term sheet from a venture capitalist, and converted to a corporation so they could sell shares of stock to the VC.
I should at least briefly talk about taxes. There are differences in how these businesses are taxed that can have an impact on the owners. An LLC has more favorable tax treatment than a corporation. However, if the corporation meets certain IRS criteria, then the corporation might also get favorable tax treatment, and be considered an “s-corporation”. You will want to talk these options over with a tax advisor before making your decision.