Choice of Entity

Before we get into the securities law issues, we should start with a basic choice of entity analysis. Although tax issues usually drive the choice of entity for most people, the capital needs of a business should also play a big role in the type of entity you choose. The two most common types of legal entities being used by entrepreneurs are S-Corporations (pass-through tax treatment), C-Corporations (tax paying entities), and limited liability companies (could be treated as either a pass-through or a tax paying entity). Here is a quick overview of each of these entities.
S-Corps:
For many an S-Corporation is the entity of choice because of the favorable "flow-through" tax status and the simplicity of organization. A corporation can be organized for as little as $100 by registering it with the Secretary of State of your state. An S-corporation, however, has some severe limitations when it comes to raising capital. IRS rules dictate that an S-Corporation can only have one class of stock (common stock) to offer investors. This prevents you from offering investors special priority returns that they typically demand. You are also limited to 75 individual investors in an S-Corporation and are prohibited from having foreign investors or other entities as investors (except other S-Corps). If you plan to raise a large amount of capital from multiple sources, I would not use an S-Corporation. You could also start as an S-Corporation and convert to a C-Corporation, but beware of the tax consequences. S-Corporation are good for small groups of participants where "prorata" distributions are acceptable to all participants. Most growing companies that need capital to survive, will quickly outgrow their S-Corporation shell.
C-Corp.
A C-Corporation has a lot to offer in terms of raising capital because you can offer different types of investors multiple classes of stock to suit their investment needs. For example, preferred stock is an easy way to offer investors special treatment so that they can get their money back before the common stockholders share in any returns. Convertible preferred stock allows investors to wait and see which is worth more (the preferred stock that carries a special dividend) or the common stock that it converts into. You can also get more complicated with "participating" preferred stock and offer investors both the right to get their money back with a stated dividend and participate in the distributions to common stock shareholders. Venture capitalists tend to have a preference over the type of security they like to use for investing depending the VC's organizational structure. Many VC's are structured as pass-through entities for tax purposes and like to make investments in C-corporations because they do not generate any pass-through tax consequences to their investors until the investment matures. This is because many investors in VC firms are tax exempt investors and do not want pass-through income because it can jeopardize their tax status. The big downside to a C-Corporation is the double taxation that results to investors and shareholders because the entity has to pay tax on all earning and the shareholders have to pay tax on all dividends, resulting in double taxation. This would otherwise be avoided in a pass-through tax structure.
Limited Liability Companies
LLC's clearly offer the most flexibility to small business owners who are looking to raise capital and take advantage of favorable pass-through tax treatment. You can offer investors the same preferential treatment that a C-Corp might offer by creating special classes of membership interests (Class A, B, C, etc.). For example, each round of capital can be offered a different class of membership interest. The trick with an LLC is drafting a good operating agreement that governs your ability to raise capital in multiple rounds without giving early investors too much control. You may also want to create a "corporate like" governance structure with a board of managers and officers similar to a corporation. This type of structure will help give each investor and participant the appropriate rights and protections. LLC's can either be a pass-through entity for tax purposes or a tax paying entity for tax purposes, so you can accommodate VC investors or other investors provided they all want the same tax consequences. An LLC is a good choice of entity when you need flexibility and are unsure of your capital raising strategy.

Key Issues:

Here are a few key questions that will help you resolve your choice of entity:

1) How much capital will I need for my business?
2) How many rounds will it take to raise the capital?
3) Who are my likely investors and what type of tax treatment do they want?
4) When do you expect to generate earnings and losses?
5) What is your likely exit strategy?
6) What is important to your investor?

The answers to these questions will help you choose the right entity for your business and may dictate that you may need to change your legal form over time. Here are some general rules to apply to the answers to the above questions. If you need a lot of capital and will need to raise capital in multiple rounds, than an S-Corporation probably won't cut it, so consider either an LLC or a C-Corp. If you want or need pass-through tax treatment, then you are stuck with either an S-Corp or an LLC. If you plan to distribute earnings or sell the assets down the road you may want to consider a pass-through entity such as an LLC or S-Corp. If your investor tells you he will give you the money provided you change your organizational structure, change it.

Now that you have a legal entity in place, you can start thinking about the securities law issues related to raising the capital! Check our next blog posting for more information on these issues.

Raising Capital

Raising capital for a small business is a difficult process. Unfortunately, state and federal securities laws do not make it any easier. Entrepreneurs in search of capital need all of the help they can get. The purpose of this blog is to help entrepreneurs understand the fundamentals of raising capital both from a legal and business perspective. I will try to post weekly updates for those interested in learning more about the process of raising capital for their small business.