MP recently spoke with Daniel Ravicher, an attorney that helps creative people develop innovative products and take them to market. He also assists investors in innovative ventures. The specific work he does for clients includes corporate, securities, transactional, intellectual property, and dispute resolution matters. He started his legal career over twenty years ago with a leading Silicon Valley law firm in their New York City office, then became an entrepreneur himself for about a decade, and most recently returned to private practice with a New York City boutique business, technology and finance firm as a partner opening and anchoring their Miami office.
MP: Why should aspiring entrepreneurs form a business entity?
DR: There are both legal and business reasons to adopt a business entity when one has an idea for a business or social venture. First, legally, a business entity provides protection for the founders of and investors in a business in that they cannot be held responsible personally for any debts or liabilities of the business. If you plan to enter into any contracts with other parties, be they suppliers, customers, employees, etc., there’s no reason to enter those contracts personally and subject your assets to the counter-party should they have any claims against the business. Second, investors in businesses cannot own part of a person or group of people, they can only own part of a business entity. If your business will seek outside investment, those investors will demand you form a business entity. Third, forming a business entity helps get a creator’s mindset settled that the idea they are pursuing is a serious one and not just one they talk about. Forming a business, opening a bank account, renting an office, and other practical steps of segregating the venture from your personal life has psychological and motivational benefits.
What’s the difference between a corporation and a limited liability company?
There are a handful of options to choose from when forming a business entity, with corporation and limited liability company being two of the most popular ones. While both a corporation and a limited liability company provide their owners the liability protection for any debts or liabilities incurred by the business I discussed before, the difference between them is the way in which they are taxed. Corporations are taxed directly on their profits, while LLCs are not. Rather, the owners of an LLC are taxed on the profits of the business. If your business has no profit, because you do not yet have a product on the market, or you plan to reinvest every dollar in revenue you get into further development and marketing, than the form of business entity does not matter, because you do not have a profit.
If you expect your business will have a profit at the end of the year, you then need to think about what you plan to do with those profits as this will dramatically impact which form is better for you. If you want to take all the profit out of the business and put it into your personal account, then an LLC is likely better, because all such withdrawals from businesses are taxed and if your business is a corporation you will end up paying double tax. For example, say you have a pizza shop and you make $1,000,000 in profits. If your business is a corporation, it will pay roughly 20% tax on that amount, leaving $800,000 left. If you then take that amount out of the business into your personal account, you will then pay roughly 30% personal income tax, leaving only $560,000 in your account. If instead your business was an LLC, it would not pay any initial tax on the $1,000,000, but rather only the 30% personal income tax, leaving $700,000 in your personal account. In this example, being an LLC saves $140,000 in taxes.
Do not assume an LLC is always the right answer, though. There are plenty of examples where being an LLC results in paying more tax, such as if you plan to open up a second pizza shop next year. If that is the case, using the same numbers above, you would not withdraw the $800,000 from the corporation’s bank account and would have that amount to invest next year in growth. If your business was an LLC you would only have $700,000 because you have to pay 30% personal income tax on the profits of an LLC whether you withdraw the money from the business bank account or not.
How do you know if you should form a corporation or a limited liability company?
I hate to sound like a lawyer, but it really depends on what your business plans are, including when you plan to make a profit (until then it really does not matter much whether you are a corporation or LLC), whether and when you plan to bring on investors (many times investors who want equity in your business, as opposed to debt or convertible debt, will have a preference as to what form of entity your business is and you have to adopt to those wishes), and what you plan to do with your profit each year (do you plan to withdraw it to your personal account or reinvest it in the business). These and other considerations should be discussed with an attorney to make sure the right decision is made as to what business entity to form. But, do not be worried if the situation changes or you realize you should have made a different decision, because it is both possible for some business entities to elect different tax treatment (an LLC for example can choose to be taxed like a corporation if it wants) and it is possible to convert from one form to another. For example, the Facebook that we all know and love was formed initially as a Florida LLC. It then later converted into a Delaware corporation (when the first outside investor came along and required that).
Are you required to form company to operate a business?
No, in fact once you have the idea for a business, you legally have a business. If it’s just you, your business is called a sole proprietorship. If your idea is to do the business with others, you have a general partnership. The problem with these default business entities is that the owners of the business are personally liable for any debts or liabilities the business incurs. This is why I always advise forming a business entity that provides personal liability protection for the owners, such as a corporation or LLC.
If you do form a company, should it be in the state where you live, or should it be in Delaware?
Again, the decision of where to form a business entity depends on specifics of the business. You are allowed to form a business entity in any state of the country you want (or indeed any country in the world if you want), but you are also required to register your business in any state in which the business has a “presence”, which means an office or store. Many people choose to form their business entities in Delaware because it has a great reputation for stable and predictable corporate law. I form Delaware, New York, California, and Florida businesses for clients all the time, as those are generally the ones for innovative businesses to select.
Does this change if my business will be a tech startup?
The vast majority of institutional investors (as opposed to angel investors) in startup companies are comfortable with, and used to, investing in Delaware corporations, so if and when your tech startup plans to accept venture money, you will need to expect that they will want to convert your business to a Delaware corporation. That can be done relatively simply at the time, or if you want you can start your business as a Delaware corporation from the beginning. As I mentioned before, Facebook started as a Florida LLC and then converted to a Delaware corporation, so that is just one example of how it can be done.
How will forming a business entity keep entrepreneurs motivated?
If there is more than one person working on the business, then forming an entity helps all those involved understand what portion of the business they own or could come to own through the business’ equity incentive programs for talent. It also helps form a culture of teamwork and camaraderie to see there is a new entity that they are all participating in creating and developing. Even for solo-preneurs, having a separate identity that represents the business can help segment it in their heart and mind as something they are building to have a permanent and independent existence.
Once a business entity has been formed, what needs to be done?
After forming a business entity, there are several administrative tasks to complete that, while not necessarily enjoyable, are nonetheless requisite, including getting a tax id number from the IRS, opening a bank account, registering with state and local government agencies, and adopting a bookkeeping process for accounting purposes. If the business has more than one founder, there needs to be private governance documentation for the business. This is often called a Shareholders Agreement for a corporation or an Operating Agreement for an LLC. We sometimes refer to these agreements among founders of businesses pre-nup agreements, because they really only come in to play when there are problems happening between the founders or one wants to leave, which unfortunately happens quite often.
I also advise new businesses to do a trademark clearance search to make sure the name of the business they want to use is not already reserved by someone else. If not, filing a trademark registration application can assure that the name is held and cannot be taken by others. The new business should also think about whether its innovative ideas can be protected by the patent laws, and if so an application should be filed as soon as possible given our patent rules say that whoever applies for a patent first on the same or similar idea gets the patent over any later applicant even if the later applicant had the idea first.
Are there any ongoing obligations entrepreneurs must be aware of when forming a business entity?
Unfortunately, yes, you have to file an annual report and fee with each state that your business is registered, and you also have to complete your annual tax returns for the business. There may also be quarterly filing obligations with the IRS, the states, and the localities with which the business is registered. While it can seem a like a lot of red tape and burden, it is totally worth it in order to make sure the personal assets of the owner(s) of the business are not at risk of being lost should the business incur any debts or liabilities it cannot cover. All successful businesses get sued. I, in fact, send a bottle of champagne to my clients when they get sued for the first time, because it is a sign that a business has finally matured. Like a bar mitzvah or Quinceañera, a lawsuit can be expensive, but it is also a right of passage into maturity. Having the corporate form to know that the lawsuit against the business cannot touch the house and bank accounts of the owners of the business provides peace of mind that dwarfs any headache caused by a few hours of annual paperwork.
Is there anything else you would like to add?
The greatest form of public service is not charity, but entrepreneurship. Using market forces to bring better, faster, cheaper products to the public is how America has evolved so quickly and beneficially for so many of its people, and indeed the world. I encourage anyone with an idea to make the world a better place to pursue it with all their effort.