Illustrations Of Choice Of Entity For The Start-Up

T. Randolph Catanese, Esq. © 1999. All Rights Reserved.

In the first three articles of this series, various business entities were discussed – sole proprietorship, general partnership, limited partnership, “C” corporation, “S” corporation, and limited liability companies.  In each of those articles the characteristics of each entity as well as some comparison to the other entities were detailed.  In this article, illustrations will be given as to why one entity as opposed to another would make the most sense for the budding entrepreneur.

In many instances, the start-up entrepreneur has the need to act quickly, but insufficient funds to properly create an operating entity.  Often this results in an unintended sole proprietorship or general partnership.  Usually, this arises where the individual or the individual with one or more partners begins to do business without any proper business formation.  When this occurs, the “default” statutes which exist in the particular state applicable to a sole proprietorship or to a partnership will apply.  These statutes will govern what occurs between the individual business owners and third-parties or between themselves in the event of a dispute.  This is not the preferred way to approach any business.

For example, if Mr. A entrepreneur decides he wants to start up internetgames.com by preparing an Executive Summary with a Business Plan, but without forming any specific business entity, he risks being treated as a sole proprietorship.  And, if he decides to note in the executive summary and business plan for internetgames.com that Mr. B is a co-shareholder (if he is in fact referred to in that way – which is common) then the two of them may be deemed partners even though no actual corporate formation has occurred and no actual stock certificate has been issued.  That means that if in the course of this relationship Mr. B goes to a printing company and asks for business plans to be printed then the liability for payment of those business plans to the printing company is a joint liability of both Mr. A and Mr. B.

Let’s take it one step further.  In this next example assume that Mr. A and Mr. B decide that they wish to form a corporation.  They fill out the appropriate articles of incorporation and file the same with the California Secretary of State.  But, they do not prepare corporate minutes, fail to set up a corporate bank account, and fail to adequately fund their business.  They then embark on their business venture and one of the first steps they take is to sign a $250,000.00 contract with a large regional telephone company to provide ISP service.  Later, when they fail to raise capital and the telephone company brings its lawsuit, it sues Mr. A and Mr. B individually and jointly for the full $250,000.00 claiming that the corporation is their alter ego­.  Given these limited facts, a court would likely find that they each have personal liability for the contract since the corporation was not properly formed nor funded.

Now, let’s take another example.  Assume Mr. X and Mr. Y decide that they wish to form an entity to grow their Internet idea.  Although it takes more time and it costs more money, each firmly agree that they need to do it “right” from the start.  So, they spend a little extra money and hire an attorney and an accountant to help them plan their business.  In the course of their consultations they agree that they will have losses, but they want those losses to be available to the “seed” investor or “first round” investor.  Also, they want the investors to have the opportunity for ease of exit for their investment.  To them, the idea is to form the company to make it easy to raise capital, have multiple levels of capital and debt and to proceed to an IPO as soon as practicable.  So, with these matters in mind they elect to form a C corporation, they incorporate in the State of Delaware, they open up an appropriate bank account, they fund the bank account with the necessary seed capital, they hold their initial board and shareholders meetings and properly document the meetings, they prepare and issue  stock certificates including corporate by-laws.  Later, Messrs. X and Y issue their executive summary and business plan to a group of investors for review.  When the investors conduct their initial due diligence they find that the business entity was properly formed and that the budding entrepreneur start taking the appropriate steps to move forward.  This impresses the investors so they take a deeper look at the investment opportunity.

Although the two examples listed above are extreme, nonetheless these types of situations occur every day in the fast paced Internet and high technology environment.  The only difference between the two examples was, in reality, the mind set of the entrepreneurs.  The one set moved forward irregardless of the consequences, whereas the other set were more cautious in their approach.

Ultimately, the founding owner or owners of any start-up must keep in mind the immediate, mid-term and end-term goals that they seek.  The choice of entity at the beginning will have a profound affect upon their ability to achieve any established goal.  With the proper foresight and discipline, the budding entrepreneur has multiple avenues available to structure the start-up business for the maximum opportunity for success.

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