Organizational Beginning Matters

Yes. Forming a legal entity can protect your personal assets from business obligations, provided you maintain it properly (see Question 6). Additionally, an entity creates a separate structure for building value, which can help in raising capital and preparing for a future sale.

You should form your entity as early as possible to begin benefiting from the protections and opportunities it provides (see Question 1).

For most emerging companies, you will likely want to form either an LLC or a corporation.  The type of entity that is best for your situation will be driven by a number of factors, including (a) tax and accounting considerations, (b) anticipated complexity of governance structure and (c) your sources and needs for capital.

Pros:

• Limited personal liability.
• Familiarity to investors.
• Potential tax advantages.
• Ease of transferring ownership.
• Perpetual existence.
• Clear governance rights and obligations.

Cons:

• Potential for double taxation.
• Costs of formation and maintenance.
• Fiduciary and legal obligations.
• Possible loss of control.

The key difference lies in taxation:

• S Corporation: Taxable income is passed through to shareholders, who pay taxes on it individually.
• C Corporation: The corporation pays taxes on taxable income (if any) at the corporate rate, and shareholders are taxed on any distributions (potential double taxation).

Additional differences:

• S corporations have restrictions, such as a limit on the number of shareholders, no foreign investors and a single class of stock, limiting flexibility in allocating income and losses.

To form a corporation, you’ll need to:

1. File articles or a certificate of incorporation.
2. Obtain a tax identification number.
3. Adopt these key documents:
   • Initial action of the incorporator.
   • First board action or meeting minutes.
   • Bylaws.
4. Authorize the initial capital contribution and subscription for shares.
5. Consider drafting a shareholder/stockholder (buy-sell) agreement.

Pros:

• Limited personal liability.
• Single level of taxation (at the member level).
• Flexibility in capital and governance structure.

Cons:

• Less familiar to potential investors.
• Possible adverse tax implications.
• Flexibility may lead to:
  • Increased complexity.
  • Lack of uniformity.

Forming an LLC involves the following steps:

1. File articles or a certificate of formation.
2. Obtain tax identification numbers.
3. Adopt an LLC operating agreement.
4. Document the initial capital structure.

Other required documents depend on your chosen governance structure (e.g., member-managed, manager-managed, or board-managed).

The initial filing fee for forming a business varies by state, typically ranging from $100 to $500. Additional costs include expenses for completing and finalizing internal documentation, such as attorney’s fees. If your primary business operates outside the state of formation, you will also need to hire a registered agent in that jurisdiction, which typically costs $200 to $400 annually.

Beyond the annual cost of a registered agent (see above), the expenses for maintaining a corporation depend on the state. These may include state renewal or franchise taxes and legal fees for documenting corporate activities. The total costs can vary significantly based on your corporation’s specific needs and location.

Where you should form your company will depend on a variety of factors, including where you plan to do business, whether you will have outside investors and who/where they are. In most cases, it will be a choice between Delaware (where >60% of all corporations in the US are formed on an annual basis) and another jurisdiction where the business is primarily located.

Advantages of forming in Delaware:

• Flexible and business-friendly corporate laws.
• Access to a dedicated Court of Chancery for resolving corporate disputes.
• Strong privacy protections for business owners.
• Widely recognized as a top jurisdiction for business formation.

Disadvantages of forming in Delaware:

• Higher annual fees compared to many other states.  Some states, like Minnesota, have no annual fees.
• Statute is poorly indexed and can be complex to use.

To maintain your entity and preserve liability protection, you should:

• File annual reports or other required filings on time.
• Keep separate bank accounts and financial records for your business.
• Act as an agent of the entity when conducting business activities.
• Document corporate governance decisions and approvals.
• Maintain proper corporate records.

Failing to follow these practices may expose your personal assets to the entity’s obligations.

• Corporations: A Board of Directors is required by law and holds fiduciary responsibility to shareholders.
• LLCs: A Board is optional and depends on the structure of your LLC and the terms of your operating agreement.

From a business perspective, having a Board with members not involved in daily operations can improve governance, provide access to expertise and contacts, and increase your entity’s chances of success.

An effective Board of Directors should include:

• Individuals with complementary skillsets.
• Members with diverse networks that can support your entity’s success.
• Thoughtful contributors who can challenge assumptions and offer fresh perspectives without being disruptive.

To run effective Board meetings:

• Schedule meetings at regular intervals (e.g., monthly, quarterly) based on the entity’s stage of development and level of activity.
• Develop an agenda that addresses key strategic objectives, current developments, challenges and opportunities.
• Share meeting materials in advance to allow Board members time to review and prepare.
• Consider discussing materials individually with Board members beforehand to gather feedback and ensure alignment.
• Involve Board members in setting the agenda to incorporate diverse perspectives.

Authorization of actions depends on the significance of the decision:

• Shareholder approval: Typically required for major decisions, such as amending the entity’s formation documents or selling/liquidating the entity.
• Board approval: Needed for material obligations, including key contracts, issuing shares, appointing or removing officers and budgetary decisions.

These actions can be approved during formal meetings or through written resolutions, as long as all legal requirements are met under applicable corporate statutes.