There are four primary forms that a startup business can take: (1) sole proprietorship, (2) partnership, (3) limited liability company, and (4) corporation. We have described the pros, cons, and principal features of each of these business forms below.
1. Sole Proprietorship
A sole proprietorship is the default arrangement for any individual conducting a business that does not take any other action to form a separate legal entity. There are no formalities that must be followed to be a sole proprietorship, and the entrepreneur has complete control over the business. A sole proprietorship is simple and inexpensive to form, and there is no separate taxation on business earnings (i.e., the entrepreneur pays all taxes). The entrepreneur bears personal liability for all business obligations.
A sole proprietorship is an unattractive arrangement for conducting a startup for the following reasons:
- there is no ability for shared ownership or equity incentives (co-founders, investors, or employees);
- there is no ability to raise equity capital (founder investment or founder borrowing only);
- there is a limited ability to enjoy capital gains on acquisition of a business (asset sale only); and
- there is no entity to sell in an acquisition or initial public offering.
A partnership is two or more persons conducting a business. A partnership is the default arrangement when multiple entrepreneurs take no action to form a separate legal entity. The partnership agreement among the partners can be oral or in writing. There is no separate taxation on business earnings of a partnership. Instead, all partners individually pay all taxes.
There are two types of partnerships: general partnerships and limited partnerships. In a general partnership, all partners are active in the conduct and management of the business and are jointly and severally liable for all partnership obligations. In a limited partnership, general partners are active in the conduct and management of the business and are jointly and severally liable for all partnership obligations; limited partners do not participate in the conduct and management of the business and enjoy limited liability for partnership obligations up to the extent of their investment. In any partnership, the allocation of profits, losses, and distribution of cash can be complex and burdensome.
A partnership can be an unattractive arrangement for conducting a startup for the following reasons:
- shared ownership and equity incentives can be complex and burdensome; and
- it can be difficult to raise equity capital because there can be investor reluctance to being liable for partnership obligations.
3. Limited Liability Company
A limited liability company is formed by filing articles of an organization or a certificate of formation with state authorities. The members of the limited liability company enter into a written limited liability company agreement or operating agreement. A limited liability company is owned by the members, with their ownership being represented by either “units” or “percentage interests,” and the company’s operations are managed by either members or managers. Members are protected from personal liability for business obligations. There is no separate taxation on business earnings; instead, members pay all taxes.
A limited liability company can be an unattractive vehicle for conducting a startup for the following reasons:
- the issuance of K-1 tax forms to each member each year can be burdensome to the startup;
- there are investor limitations on the ability to invest in “flow through” entities such as limited liability companies; and
- in an initial public offering, the equity markets will demand conversion to a corporation.
A corporation is formed by filing a certificate of incorporation (in Delaware) or articles of incorporation (in California) with state authorities. A corporation is owned by shareholders, operated by officers, and overseen by a board of directors. Shareholders are protected from personal liability for business obligations. A corporation generally has a separate taxation on business earnings, and formalities must be observed to maintain existence and shareholder protection from liability for business obligations.
A corporation is an attractive vehicle for conducting a startup for the following reasons:
- venture capital investors generally prefer making an investment in preferred stock of a corporation;
- all shareholders are bound by non-contractual charter documents that are approved by the requisite number of holders (even if not unanimous); and
- an initial public offering generally is conducted through a corporation (with the issuance of common stock).