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Thursday, March 17, 2011

Forming the Company & Structure - part of starting a company

This is the fourth article in the series. If you just started reading this article, you may want to read the others as well.  They are in the archives and can be retrieved. 

The topic for this discussion is generation of the business entity you are about to create.  Keep in mind, I have discussed that you must have resources to survive personally for a prolonged period.  Don’t start a company when you do not have any means of financial support.  DO NOT think you will draw a salary soon.  It is not likely to happen!

In starting the technology based business, which comes first, the Company or the Technology?  It is a bit like the chicken and egg story; it really doesn’t matter.  You can create the company and fill it with technology; even it is years later.  You can find technology and create the company overnight (or in a few days).  Either option can be made to work. 

The more important issue to resolve is the type of structure you want the business to have; a Corporation, a Limited Liability Company, or some other structure.   These structures are defined as below by www.investorwords.com :

Corporation:  “The most common form of business organization, and one which is chartered by a state and given many legal rights as an entity separate from its owners. This form of business is characterized by the limited liability of its owners, the issuance of shares of easily transferable stock, and existence as a going concern. The process of becoming a corporation, call incorporation, gives the company separate legal standing from its owners and protects those owners from being personally liable in the event that the company is sued (a condition known as limited liability). Incorporation also provides companies with a more flexible way to manage their ownership structure. In addition, there are different tax implications for corporations, although these can be both advantageous and disadvantageous. In these respects, corporations differ from sole proprietorships and limited partnerships.”

Limited Liability Company: Often abbreviated as an LLC. “A type of company, authorized only in certain states, whose owners and managers receive the limited liability and (usually) tax benefits of an S Corporation without having to conform to the S corporation restrictions.”  

There are many to several structural aspects which are available for the business and the best way to select the right one is with a good discussion with your attorney or accountant.  The choices between limited company or a corporation have a lot to do with taxes, payout of cash, and ownership.  There are pluses and minuses for each and you need to weigh the differences depending where your needs are in the future.  I have always been associated with companies which are C corporations.  As defined in Wikipedia:

A C corporation is a corporation in the United States that, for Federal income tax purposes, is taxed under 26 U.S.C. § 11 and Subchapter C (26 U.S.C. § 301 et seq.) of Chapter 1 of the Internal Revenue Code.  Most major companies (and many smaller companies) are treated as C corporations for Federal income tax purposes.

The income of a C corporation is double taxed, whereas the income of an S corporation (with a few exceptions) is not taxed at the entity. The income, or loss, is applied, Pro Rata, to each Shareholder and appears on their tax return as Schedule E income/(loss).

Unlike corporations treated as S corporations, a corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.

The C Corporation has been the structure desired by the funding sponsors affiliated with nearly all of the companies I have had an involvement.  A C Corporation is registered with a state (Delaware for example) by filing the appropriate documents.  There is a filing fee.  You can work with an attorney to file the forms and your counsel will generate all the paperwork associated with the company creation.  I have gone through the process without legal assistance, but would not recommend it to someone just starting out.  There will be associated costs of as little as a few hundred dollars to more than a thousand.  It depends on the complexity you want to add, what your counsel does, and the billing rate.  ASK the billing rate before you start and get an estimated total cost.  Why suffer sticker shock!

You will need to obtain a tax ID code from the IRS.  A corporation is like having a separate person to account for with respect to the state and federal government.  The corporation will have regular tax and reporting obligations even it has no source of revenues.  You will need to request an EIN number from the IRS; this is like a SSN for a company.  The EIN is to be your Tax ID for all future filings.  Your legal or finance advisor can help obtain the EIN and help with all of future filings.  I do not recommend that you try managing the filings yourself.  You are likely to get notes from the state or IRS telling you missed dates, the estimated tax or paid taxes are not correct, or other notes not so pleasant.

When you form a corporation or a LLC, you will have ownership that will be represented by issuances of shares.  These shares reflect your fractional ownership of the business.  For example, if you and your partner own half of the issued shares each, you each own half of the company.  The control of the company is 50:50 as well and the voting of the shares will carry equal weight; unless you have created a structure defining different classes of shares with different voting rights.  Keep in mind that when you have critical decisions they are often put to a vote by the shareholders.  A 50:50 ownership could result in ties unless you have other arrangements in advance to break such ties.  How you divide the shares and structure the control of the company will be an important consideration.  Again, your mentors, legal assistant, or financial person, can help if you take the time to discuss it and listen to their advice.  Most of the structural issues can be changed later by your legal representation, but it will cost you money!  Try to get it close initially and do not rush the decisions.  Discuss what you want to accomplish with your mentors and advisors be for you finalize your decisions.

I was involved in just such a company creation within the last few months.  A business decided to generate a spin-out of part of an existing company to a new company to be formed in Maryland.  It took a few weeks to complete the documentation and form the structure.  The CEO/Founder was not familiar with the process and he effectively used his mentors, as well as his finance and legal advisors.  This helped speed the process.

Following the formation of the company, a Board of Directors needs to be selected.  Yes you will need one of those!  If you thought you would not have a Boss that is not correct.  Most everyone has a Boss of some type.  The Board of Directors has the responsibility of oversight of the company and the responsibility of oversight and direction of the Senior Management.  This is often done by review of activities and setting milestones for management to achieve.  They review the finances and ensure accuracy in reporting and spending.  The Directors have a legal responsibility to ALL investors to ensure proper and ethical management of the company.  They will be your Boss. 

The members of the Board of Directors are elected by the shareholders, on the first day of formation of the company you may be the only shareholder and own 100% of all issued shares.  But as investments are made and shares issued to new investors, your percent ownership will be reduced.  Don’t be surprised if your 100% ownership eventually drops to 10% or less as you get funds from selling shares.  This means the Board will have a stronger representation from the investor pool and that your Boss has more stronger connections to new Shareholders than to you.  Please do not get hung up on DILUTION at this point.  I will try to discuss dilution in a later article.  Suffice it to say, it is better to have 10% of a lot of money than 100% of nothing.

I plan to discuss issues of early finances next in the mean time you may want to read an article written by Martin Zwilling:   http://blog.startupprofessionals.com/2011/03/most-startups-get-no-professional.html  
Martin published this blog recently and it covers most of what I will be discussing on the early financing options you may have.  After you are clear on early money, I will start some of the discussions around technology. 

I hope you will let me know if you have key issues you want discussed out of sequence.  I can either deal with them via email or by the blog.

Taffy Williams is the author of:  Think Agile:  How Smart Entrepreneurs Adapt in Order to Succeed to via Amazon