You had an idea, you had a vision, and it’s starting to come to life. You’re ready to launch your business, but you’re not sure whether you should just go for it and start landing customers, or whether you should take the time to form a legal business entity. Below are some frequently asked questions that can help determine whether forming a business entity is the right choice for you.
Do I need a business entity?
If you’re a single person operating a business without a formal entity, you’re already a sole proprietor—with two or more people, you’re operating as a general partnership. Why does this matter? Well, you’re already operating a “business” informally, but you don’t have anything to protect you from personal liability associated with your business activities.
The shield against personal liability is arguably the most important consideration when thinking about whether you need a business entity or not. Certain business entities like LLCs and corporations shield their owners from legal and financial liability. However, this is not without limitation; you need to ensure you’re forming a business entity to run a legitimate business, and not just as a means to protect you from liability in your personal dealings.
Liability aside, having an entity with a defined governance structure can make it easier to tackle the day-to-day, as well as larger decisions that may arise. Having an entity also signals legitimacy to potential customers, vendors, and investors who may be reluctant to do business with an unincorporated venture.
When should I form a business entity?
If you’re going to be offering a product or service to customers, having a business entity is crucial to limit your personal exposure to liability. While we hope nothing ever goes wrong with your product or service, if it does, you certainly don’t want to personally be on the hook for whatever liability arises.
Also, if co-founders are involved, the earlier, the better. It’s usually easier for multiple founders to agree on things like the content of governing documents, appointment of management, and other aspects of business operations in the earlier stages. Down the line, not only might there be disputes among co-founders, but it also may be more difficult to resolve disputes without an entity that has established decision-making procedures.
Generally, you want to form an entity as soon as possible. There’s often much less risk involved with forming an entity and not actually operating a business, versus operating a business and not having an entity in place.
What type of entity should I choose and why?
The vast majority of businesses are formed as Limited liability companies (LLCs) and corporations. There are some key considerations when thinking about which is best for your business.
First, in terms of organizational structure and management, corporations are much more rigid than LLCs. Corporate statutes clearly define the management structure and voting rights at each level of management and ownership, whereas LLCs laws are much more flexible and leave decisions about management and governance up to the members.
Another key consideration is the future capitalization of your company. There may be a point at which you look to venture capital (VC) to fund your company. Much more often than not, you’re going to be required to operate as a corporation to receive VC funding. Why would a VC care which type of entity you have? The answer is qualified small business stock (“QSBS”).
VC transactions involve giving up equity in your company, which means the VC that provided the funding becomes a shareholder of your corporation. Provided that the requirements to be considered a “qualified business” are met and depending on when a VC became a shareholder and how long the stock is held, a VC can exclude from taxation up to $15 million (or ten times their investment) in gains from the sale of your shares—a significant incentive for investors.
There are also tax considerations applicable to owners that can factor into which type of entity to choose, and it’s always best to consult with a qualified accountant about the tax advantages and disadvantages of LLCs and corporations.
What is the legal process for starting my business?
It’s actually quite simple in Indiana, in particular. First you determine what the name of your business will be and which type of entity you want to form. It’s important to check whether the desired business name is available.
Once you have those basics set, all Indiana requires is that you file articles of incorporation (corporation) or organization (LLC) with the Secretary of State, accompanied by the required filing fee. You’ll also want to adopt bylaws (corporation) or an operating agreement (LLC) to establish internal governance rules, and obtain an EIN from the IRS. The process is more or less the same in other states, and keep in mind that you can always file for foreign registrations if you want to operate beyond the state your entity is formed in.
Anything else I should be thinking about at this stage?
Practically speaking, you should also consider intellectual property assignments, nondisclosure agreements, and equity vesting agreements for founders and other involved in the business. Ownership interests should be clearly laid out in the organizational documents.
One other very important thing to check is whether you or any co-founders are bound by restrictive covenants from former employers—anti-moonlighting clauses or covenants not to compete. If there are active restrictions imposed upon any of the founders, consult with an attorney to determine what options are available while those restrictions persist. One of the last things you want while getting your business up and running is a founder being bogged down by a lawsuit from a former employer.
If you have questions about forming your business, please give us a call at 317.423.7900 or send us an email at info@gutweinlaw.com.
This blog post is part of our 5-part series on Fundraising for Startups. To view other parts of the series, click the links below:
