Choosing the Best Entity for Your Startup

How to Choose the Best Entity for Your Startup

Last Edited January 25, 2018 by Garenne Bigby in Business

So, you’ve decided to try your hand at entrepreneurship and start your own company? Whether it’s a full-time commitment or just a means of supplementing your existing salary part-time, this is an exciting time for you.

The first stumbling block you may encounter is how to register your business. What’s the right business entity to choose? There are four basic business types, with a few common alternatives that should certainly be taken into consideration too. Every single one of them has its own set of pros and cons.

business entity types feature

Deciding on your business’ legal structure is one of the most important steps of the startup process. Your choice will have a major impact on liability, taxes, control over your company, and a host of other factors. The way your business is run can (and most likely will) be greatly affected by the type of business entity you choose.

Understandably, this can make new business owners a little wary. You certainly don’t want to make the wrong choice. So how do you pick the right one? We’ll let you in on a well-known secret: there is no single “right” business type. There isn’t any single “best” choice either.

The trick is to find the best business entity for your particular company, based on your goals. You need to sit down and consider every factor. Once you know exactly what each entity type’s strengths and weaknesses are, it’s up to you to decide which type will give your business the best advantages.

Remember: you have personal, organizational, and financial goals when you start a company. Your chosen business entity should help give you the right foundation for achieving those goals by clearing pathways, rather than blocking them.

To help you with choosing the best entity for your startup, we’ve outlined not only the four basic types, but their common alternatives as well.

Business Entity Types

Sole Proprietorship

Sole Proprietorship

Sole proprietorship is the simplest, most common business entity. Registering your start-up under sole proprietorship is the fastest, cheapest means of doing so. In fact, according to the Small Business Administration, over 70 percent of US businesses are registered as sole proprietorship.

This is a business model wherein one person is singularly responsible for the company. He or she is in charge of all of the business’ profits and debts. As the sole owner, he or she is answerable for all of the company’s operations. Essentially, you are your business: the startup is registered in your name, and you are answerable to no one but yourself. This means that any sales or transfers can be done at your discretion, as you have full decision-making power and control over your business.

With sole proprietorship, your start-up also benefits from being exempt from corporate tax payments, and there are few formal business requirements.

Sole proprietorship is a business structure best suited for small and medium enterprises (SMEs). If you plan on working alone, especially for a lengthy period, then it’s a great option. However, there are a few disadvantages to sole proprietorship.

As mentioned already, with sole proprietorship—and because the company is in your name—you are held personally liable for any debts and expenses. Your personal expenses are essentially joined with the business, making you responsible for all financial issues relating to the company.

On one hand, this does make things a lot simpler. But come tax season, or in the case of a lawsuit being filed against your startup, things can get messy very quickly. And because of the risks involved, not many investors are willing to put money into a company under sole proprietorship.

This liability also extends to covering the actions of your employees, which adds mounting pressure to you as an owner when it comes to training and equipping your staff.

Some sole proprietors elect to file for a DBA—“doing business as.” A DBA’s purpose is typically marketing related rather than for pure business reasons, as it effectively gives a more professional appearance to your sole proprietorship.


Partnership

Partnerships

A partnership allows for the startup to be owned by two or more people. This business entity exists in two forms: general partnerships and limited partnerships. With the former, responsibilities and rewards (profit) are shared equally, while limited partnerships allow for one partner to retain full control over the company. In a limited partnership, the second partner (and any others) share some of the financial responsibilities and receive a measure of the profits, but have little or no control.

Let’s take a look at each in greater detail.

Dual / General Partnership 

With two owners, a general partnership allows for dual status as sole proprietorship. Essentially, what this means is that the startup is registered under both partners’ names, and they each have equal shares and responsibilities. Effectively, it’s almost exactly the same as sole proprietorship, except that there are now two owners instead of one.

The principle also applies to general partnerships where there are three or more equal partners.

General partnership allows for company responsibility to be shared in equal measure between all the partners. No one partner has more authority than any other, and you are answerable to each other. This allows for business decisions to be made by majority vote rather than relying on one person. Because all partners are giving equal status, sometimes regardless of the size of their investment, they each have the full legal right to contest any business decision if they feel it would hurt or hinder the company. After all, as with sole proprietorship, all partners are personally responsible for financial issues such as debt and lawsuits.

This financial liability still covers actions by employees, as well as other partners. Other major similarities between sole proprietorship and general partnership include the cheap, simple, and fast registration process. Once again, there are few formal requirements, and the company is exempt from corporate tax. Instead, profits are shared between the individual partners—as are any losses.

In this way, general partnership does not clear the blurred line between personal and business finances. However, having one or more partners does give some small level of extra security, as the expenses are shared equally.

Another great boon that general partnership affords a startup is the ability to delegate business responsibilities to partners according to skill sets and strengths. Additionally, a business registered under general partnership is typically more attractive to potential investors than a sole proprietorship.

Of course, unless roles, responsibilities, and personal liabilities are not properly discussed and set in place, there is the potential for general partnership to create some confusion among partners regarding these factors.

Limited Liability Partnerships

Limited Liability Partnerships (LLP), or limited partnerships for short, are similar to general partnerships in many ways. Essentially, it’s merely a variation of the same structure. With a limited partnership, the company can still be registered via a quick, inexpensive process. Additionally, the business itself retains the advantage of being exempt from corporate tax payments.

However, the power dynamic of a limited partnership does differ greatly from that of a general partnership. In a limited partnership, the founding partner is the one whose name is attached to the company, and he or she keeps the majority of control and authority. While business decisions will still likely be put to a majority vote, the founding member has veto power over the collective decision if he or she so chooses.

Roles and responsibilities within the company may still be delegated according to skill sets and investment. There is also no formal obligation for individual partners to consult the other members in certain decisions.

For this reason, individual partners are better protected in terms of financial liability. If an independent decision by one partner or section has a negative effect on the business, the other partners cannot be held accountable for assisting financially in terms of debts and/or lawsuits. This is extended to the actions of employees not under their direct authority—a partner in charge of one department cannot be held liable for any negative action made by another department. Essentially, in most cases, the worst case scenario for limited liability partners is that they can lose their original investment.

In order to protect the business’ integrity, in the case of allowing individual partners to have full control over certain sectors without having to consult other partners in any decision-making process for that department, a partnership agreement must be written up giving clear outlines on the exact limitations of each partner. This way, individual partners are further protected, as well as the company as a whole.

With regards to taxes, the same structure essentially applies. Each investor is compensated via the company’s profits according to his or her original and continued investment, as is individually responsible for his or her taxes based on that income.

Limited liability partnerships are even more attractive to potential investors than a general partnership because of this individual security. It also frees the company to sell limited partnership shares to investors.

That said, limited liability partnerships are not a common choice for entrepreneurs, as there is no built-in protection for the founding member. The advantages of being more attractive to investors because they can essentially “buy” a partnership are often out-weighed for startup owners by the risk entailed. The founding member remains fully responsible in terms of finances, and as such is expected to contribute to alleviating a partner’s burden in the case of debt or lawsuits.


Limited Liability Companies

Limited Liability Companies

Limited Liability Companies follow a corporate structure. It’s essentially a hybrid of sorts. Unlike an in a partnership, members of a Limited Liability Company (LLC) cannot and are not held personally liable for any debts, lawsuits, or other financial liabilities of the business. The only provision for this is that they cannot be proven to have acted in any manner that is illegal, unethical, or irresponsible in carrying out the company’s activities.

However, similar to a partnership, limited liability company members enjoy some flexibility benefits.

Limited Liability Companies do adhere to a more formalized legal structure, which allows for personal expenses and assets to remain separate from those of the business, including its debts. While there is an agreement in place for the governance of company operations, there is no longer any buy-sell motion, which typically leads to some issues when some members contribute more or less than others.

As you’ll have noticed, the idea of “partnership” is replaced with that of “membership” with an LLC. Unlike a partnership, there are no limitations as to how many members there can be. Entrepreneurs enjoy greater flexibility, as ownership can be separated into classes. This creates a more open means of raising equity financing.

Another difference is that, while partnerships by definition require a board (and therefore annual meetings and someone to record minutes), a limited liability company does not. This can further assist in simplifying the business’ structure. Some LLCs still choose to have a board, but it becomes a matter of preference rather than requirement.

Because the structure of a limited liability company is more formal than that of sole proprietorship and partnerships, the registration process is not as simple and does cost more. Registering as an LLC is typically best suited for startups that have reached a development stage where your company may be attractive to angel investors, but not yet to venture capital (VC) investors.

In basic terms, your business is not entirely self-sufficient yet, and you still expect to make some losses (although the losses should not be 100% guaranteed). Angel investors are attracted to such companies because of the potential tax reductions. Venture capital investors, on the other hand, prefer investing in a corporation’s stock rather than in purchasing membership.

There are two types of limited liability companies that should be taken into equal consideration: public and private.

Public

A public LLC corporation trades publicly on the stock exchange, requiring public disclosure of their true financial status to allow investors to determine stock worth. Public LLC corporations are tightly regulated.

Shareholders enjoy limited liability. In the case of court proceedings or bankruptcy, their obligations are limited to that of their own investment. There is no limit to the number of shareholders allowed, and the company is, therefore, able raise a larger capital than partnerships or sole proprietors. Shareholders also enjoy liquidity, being free to transfer their shares at any time and their discretion.

The main drawback for the founding owner is that, should a particular violation or dispute arise, he or she may lose control over the business. 

Private 

Privately held LLC businesses do not trade their stock publicly and are therefore not regulated as strictly.

While shareholders still enjoy limited liability and perpetual succession (because the company is not tied down to any one person), the number of shareholders is limited to a maximum of 50. Although this still allows for a minimum of two directors, it does not give shareholders the same freedom in terms of their liquidation options.

Furthermore, because the shares are not freely transferable, private LLC companies don’t have the same capital growth potential as their public counterparts do. The limitation on the number of shareholders allowed prevents membership status from being a perk of promotion for employees.

However, with the lack of strict regulation, the management and conduct of business affairs enjoy more flexibility than in a public LLC.

 

Corporations

Corporation

Similar to LLCs (both public and private), a corporation is legally regarded as a separate entity to its owners. Independent of the owners, a corporation has its own legal rights, and has the freedom to both own and sell property, as well as transfer ownership through a sale of stocks. Furthermore, a corporation may both sue and be sued.

The two main types of corporations are C corporations and S corporations.

C Corporations

If you have set your sites on attracting venture capital (VC) investors rather than angel investors, then registering your business as a C corporation is a good option. Because the corporation is regarded as being separate from the owner (or owners), your startup’s debts, taxes, and legal structure are similarly kept separate from your own.

As can be deduced from this, a corporation offers shareholders the same security in terms of limited liability as an LLC or limited partnership does.

C corporations introduce a new level of structure to a startup, including a requirement to hold annual board meetings and record minutes. A corporation is naturally taxed on corporate profits, but as a startup especially this is not much of a con.

The reason venture capital investors are more comfortable investing in C corporations as opposed to LLCs, partnerships, and sole proprietors is that the added structure grants better security for them.

S Corporations

S Corporations derive their title by taking advantage of Subchapter S of the Federal Internal Revenue Code. This grants them tax exemption for corporate income, unlike C corporations, both at a federal and state level.

S Corporations still give the added benefit of separating business from personal, affording the owner and shareholders limited liability. However, there are restrictions and limitations on the number of shareholders allowed for an S corporation. Your startup will also be limited to a single stock class, negating any ability to do multiple financing.

This can be seen as the biggest con, as it also makes the corporation less enticing to venture capital investors. Most startups don’t feel the tax benefits until the business has grown to a point where exemption from corporate tax payments has the potential to be a game changer. S corporation status is a prime example of where you need to take your long-term business goals in mind when deciding on your startup entity.


Factors to Consider

Even with your new understanding of the common business entities, you may still be at a loss as to which one is the best choice for you. It’s not uncommon for startup entrepreneurs to be stuck between two business types.

If you find yourself in this position, then taking the following factors into consideration can help you narrow down the decision.

Complexity

As a startup, and with regards to operational complexity, sole proprietorship is most certainly the simplest option. All that’s required is that you register your business under your own name, then report profits and pay taxes as personal income. The main difficulty you’ll find yourself in is in getting outside funding. Partnership helps with this but requires a signed agreement to define roles and profit splitting. LLCs and corporations have a far more complicated setup and reporting requirements, both on a state and federal level.

Liability

Sole proprietorship means you, and you alone, are liable for all damages and expenses. Partnership shares this liability between two or more people. An LLC offers better liability protection for shareholders while retaining the tax benefits of a sole proprietorship. Corporations offer the best personal liability protection. While creditors and dissatisfied clients may sue the business, the owner and shareholders are fully protected. However, corporations are liable to pay corporate tax.

Taxes

As the owner of a small business, especially a startup, you want to avoid being taxed twice (personal income and corporate tax). Sole proprietors, partnerships, and LLCs all pay tax on personal income, as this is how profits are managed. Many accountants typically advise partners to claim quarterly or biannual advances to minimize your return’s end effect. Corporations, on the other hand, pay tax on profits after expenses, which include employee payrolls. As the owner, your business will pay corporate tax, and you’ll pay personal income tax afterward as well. This is typically done annually.

Control

Sole proprietorship or an LLC is best suited for startup owners who want to maintain sole or primary control over the company and its activities, but this can also be negotiated when developing a partnership agreement. In the beginning, the same can be said for corporations. However, as the business grows especially, it will have to become more board-directed. Even as a small entity, a corporation is still subject to the rules applied to larger organizations (such as board meetings and minute keeping).

Capital Investment

Outside funding can sometimes make or break a startup. Bank loans, investors, and venture capital all tend to favor corporations. An LLC also enjoys some attractive value to investors, but far less than a corporation. Partnerships and sole proprietors will have a hard time of gaining funding from outside the business.


Final Words

After registering your startup, it is still possible to convert the company to a different entity at a later stage. For this reason, you shouldn’t be overly stressed about your initial decision, so long as it is in line with your long-term goals.

However, it is always going to be preferential to decide on your business entity in the beginning and stick with it. Changing from sole proprietorship to a corporation, for example, is a long and difficult process. It remains our recommendation to fully consider not only your current status, but your long-term business goals and financial projections to make the right choice.

If you feel that you need any further help in making a decision, we urge readers to consult a lawyer.

Garenne Bigby
Author: Garenne BigbyWebsite: http://garennebigby.com
Founder @dynomapper
Garenne Bigby is freelance Chicago developer and founder of DYNO Mapper with over 10 years experience in both agency and freelance roles in design, development, user experience, SEO, and information architecture.

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