Entity Formation Part 1 of 3: When Should You Form an Entity for Your Business?
A common question for entrepreneurs launching a venture is when to form a legal entity such as a limited liability company or a corporation. Before discussing when to form an entity, it is helpful to understand the risks associated with operating a venture without organizing into a formal legal entity. In fact, prior to formally establishing an entity, the law will attribute a particular status to you. If you are a single member operating a business, you are assumed to be a sole proprietorship, and if there are two or more members, your business will be an assumed partnership. It is seldom the case that an entrepreneur or team of entrepreneurs would be comfortable operating in either of these forms.
A sole proprietorship is not an entity, it just refers to one person who runs a business and is responsible for those business debts. It can operate under the individual’s name, or under a company name. Sole proprietorships are easy to maintain and there are few formalities involved. If you decide to actually operate a business as a sole proprietorship, you will likely have to get a business license in the state you are operating in. Otherwise, there is little that goes in to setting up a sole proprietorship, and you may already be operating as one. The shortcoming of a sole proprietorship is that the individual remains personally liable for the company’s debt and obligations. If you wish to limit your personal liability, it is important to create an entity that provides limited personal liability (like an LLC or corporation).
If you are setting up a company with a partner and you have not yet taken steps to create a business entity, you might be operating as a general partnership. All that is needed to establish such relationship is evidence of two or more people involved in a venture with the intent to share profits. A company can start out as a sole proprietorship, but when it brings another person on it will change into a partnership. Being recognized as a general partnership means that all partners have personal liability for the debts and obligations of the company, similar to the sole proprietorship. However, general partnerships can be more dangerous than sole proprietorships because your partner(s) can bind you to obligations or contracts they agree to. Another issue is that if you have no agreement in place between the partners (which is not required in order to be considered a partnership), the default terms of the state apply. This means if there is a disagreement about what percentage of profits and losses each partner receives, the state will impose a default arrangement (e.g., 50/50 or 25/25/25/25), which may not have been what the partners had intended. A binding partnership agreement can usually resolve a lot of the issues that come up, but it will still not rectify the personal liability issue, so partnerships are rarely ideal for technology startup ventures.
Accordingly, a primary reason to form an entity is to shield the founders from the personal liability. As explained above, absent a formal entity, founders are likely subject to personal liability as a sole proprietorship or partnership. Activities that expose founders to liability (absent a legal entity) include: entering into contracts with third parties, testing technology where there is a risk of economic or personal injury, or retaining workers to perform services for the venture.
Aside from limited liability issues, there are certain trigger events that will encourage the creation of a formal entity:
- Financing: if you wish to pursue financing, setting up an entity is usually a good idea; this way, you can give your investors equity shares in the company. Investors will also usually wish to see you set up in a formal structure for liability reasons.
- Patent: if you are looking to patent a product or technology that is a part of your company, it may be a good idea to set up an entity that you can assign that patent to. That way the patent is the intellectual property of the company, and not the property of individuals. With proper agreements in place, if an individual leaves the venture, the rights in intellectual property created by that individual will remain with the company.
- Adding people to the company: if you wish to hire new people, it may be good to have an entity in place. This can put in place liability protections for the actions of your employees, as well as allow you to create option pools to incentivize employees to stay with the company. Also, because you will likely enter into a contract with your employees (employment agreements), it is good to have an entity that can enter into this contract.
- Want to enter into contracts: if your company is at the point that it wishes to enter into contracts, it is a good idea to set up a formal entity so that you can enter into contracts on behalf of the company, as opposed to on behalf of yourself.
There are many considerations that go into deciding to create a formal entity. There are some formalities and requirements to maintain your entity. So, usually companies wait until they are a bit farther along in the process than just having an idea. However, if you want the limited liability protections, or you have multiple founders working on the enterprise, it may be a good idea to form an entity and get an agreement in place to detail each founders roles, profits/losses allocations, and voting power.