Startup Best Practices

Innovate Capital wants all entrepreneurs to make as few mistakes as possible when you start your business – whether you are a client of ours or not.

We hate to see promising businesses lose opportunities to raise capital because their early mistakes scare off investors.

The following FAQs are designed to help you avoid the most common mistakes.

When should I form an entity to conduct business?

Forming an entity too early can waste resources and cause you to choose the wrong type of entity.

When you are still in the planning stages, you don’t need an entity to protect you from liability, because you aren’t selling a product or service yet. Talk to your accountant about whether there are tax reasons to form an entity, such as whether it’s better for justifying deduction of business expenses.

Likewise, if you are the only person working in a business as an employee or contractor, forming an entity doesn’t really add that much protection from liability.  But if you are working with a partner, it’s good to form an entity (typically an LLC or a corporation) once you leave the planning stage (otherwise you are deemed to form a “partnership” and will be subject to personal liability).

Is it OK to use Legal Zoom and similar services to organize my entity?

Legal Zoom provides credible form documents that work for many startup companies until they bring in investors. You might not need more than Legal Zoom forms if you are running a business by yourself. When you bring in partners or investors, the issues usually require legal counselling and a more complex set of documents.

What type of entity is best?

There is no one size fits all best choice.

Generally, there are three primary choices: limited liability companies (which are taxed as partnerships or Subchapter S corporations), Subchapter S corporations and Subchapter C corporations.

The biggest differences are in tax treatment.

Subchapter C corporations are taxed as separate persons for Federal income tax purposes. This raises the possibility of double taxation—the corporation pays a tax on profits and owners pay a tax when they receive dividends. Many Subchapter C corporations pay little or no taxes, however, because they pay all their excess (the owners) cash in the form of salary and bonuses. This works if all the shareholders work for the company. Shareholders who don’t work for the business would not want all profits to be paid in salary and bonuses.

Limited liability companies and Subchapter S corporations are both “tax pass-through entities.” That means they do not pay Federal income taxes. Instead, the owners are taxed on profits, whether or not the company distributes money to the owners.

Recent reductions of the Federal corporate tax rate to 21% (previously 35%) and potential reduction in the effective tax rate differential between corporate and pass-through entities could impact the choice of whether to use a pass-through entity or corporate entity.

Talk to your accountant to assess how the specifics may play out for your company.

How does my exit strategy affect the type of entity I should form?

The biggest exit strategy issue when you choose what type of entity to form is that if you are likely to exit by licensing patents or IP in exchange for a royalty stream, you do not want to have the intellectual property you will license be owned by a C Corporation. That would be a very expensive tax mistake that causes double taxation of the royalty stream.

There are other tax differences but having double taxation on royalties can prove to be a big tax mistake you can make when starting up.

Typically, Angel groups and VCs do not want to invest in a limited liability company and IPOs for LLCs are rate, so if you think you might need to raise outside capital or want to conduct an IPO, you may want to start with the corporate structure (though converting from an LLC is not hard),

What are the primary differences between the two types of “tax pass through entities”?

The primary differences between S-Corporations and limited liability companies are:

• Absent filing an election with the IRS, limited liabilities are taxed under partnership tax law. This has a wide range of implications, including how you structure equity compensation for employees. Partnership tax law raises more complex issues for equity compensation than corporate law raises.
• The owners of limited liability companies pay payroll taxes on all the profits the company makes. Owners of S Corporations pay payroll taxes only on their salaries assuming their salaries are reasonable for the services provided. Payroll taxes include Social Security and Medicare. This difference means that in some instances owners of an S Corporation can pay lower payroll taxes than owners of limited liability companies.
• Stockholders of corporations that meet a five-year holding period may be entitled to claim certain exclusions from income tax and AMT upon sale of their shares, but this benefit is not available for shares of an S-corp.

Talk to your accountant to learn more.

What type of entity is best for raising capital?

There are a number of factors related to capital raising you should consider when deciding how to form your company. These factors include:

• Whether you intend to issue more than one class of stock (i.e., a preferred shares); which is prohibited for S Corporations but is okay for both C Corporations and limited liability companies.
• How many investors you intend to have. There is no limit on the type or number of shareholders a C Corporation may have, or a limited liability company can have. S Corporations, in contrast, can only have 100 shareholders and cannot have entities (no VC funds, SPVs or corporate investors) or foreign shareholders—all shareholders must be individual U.S. residents or citizens.
• Who you intend to attract as investors. Historically, Angels and Venture Capital investors favor investing in C corporations rather than “tax pass-through entities” like LLCs, but some VCs are being more flexible about investing in LLCs.
• Whether you want to issue equity compensation to employees, which is typically easier to structure through a corporation.
• Again, what kind of investors you hope to attract. Some investors want to invest in “tax pass-through entities” like LLCs and C Corporations—especially if they have other passive income because they can use losses to shelter.
• Reinvestment strategies. Some investors fear they will be taxed on “phantom income,” if they invest in a “tax pass-through entity.” Phantom income is profit that the “tax pass-through entity” decides to reinvest in growing the business rather than distributing it to the owners.
• Tax implications. If you have a lot of investors in a “tax pass-through entity,” preparing the annual Form K-1 for taxes can be time-consuming and expensive .

What should I do to make sure my company owns all the intellectual property it is developing?

First, make sure the current or former employer of the founders does not own IP the founders created. Check all agreements the founders signed with their employers. Also, document the dates inventions occurred to make sure they occurred after employment terminated. Save all these documents. Investors will want to review them when they conduct due diligence.

Second, have all employees, contractors and vendors sign agreements that clearly state the company owns the IP associated with all their work product.

What are some common startup mistakes?

Common startup mistakes include:

• Not documenting agreements among the founders about how many shares each owns and vesting requirements.
• Not documenting IP ownership as described above.
• Violating wage and hours and other employment related laws by treating people who provide services as contractors when they really meet legal criteria for being employees, which creates payroll tax liability.
• Issuing securities to investors (particularly “friends and family”) without proper documentation, approvals or exemption from state and Federal securities laws.

Innovate Capital can help you with all these startup issues so that you’ll be ready to close your deal when investors start kicking the due diligence tires on your business.

What choices do I have when I raise capital?

The good news about raising capital is that you have lots of choices.

The bad news is that you have lots of choices. It can get confusing.

The following graphic illustrates how you can finance a business from startup to exit.

At each step you face choices that are impacted by many factors. Innovate Capital’s mission is to help you sort through the choices and develop a customized capital raising plan for each stage of your development.

There are at least a dozen types of financings and as many types of securities you can sell. That combination produces more than 100 choices.

Here are some of the many factors Innovate Capital considers in helping you design your customized capital customized raising plan. How you combine these factors determines answers to questions like:

• How much money can I raise?
• When do I need the money?
• How much can I invest in the offering process?
• Who can I sell securities to?
• How can I communicate with investors?
• How much of my business will I have to give to investors?

Innovate Capital’s business is to help you develop customized capital-raising plans that include the best combinations of these factors based on your resources and goals.
You have two choices:

Contact us to find out more about your customized capital raising plan…

OR…

Wing it and hope for the best.