The tech world is enamored by spectacular rags-to-riches stories—well, not quite rags, but modest beginnings. Businesses that were conceived in a garage, attic, or bedroom and grew to become multi-billion dollar behemoths. It’s with this context that people launching a startup often seek to keep things simple at the beginning.
One of the key decisions in this regard is the kind of business structure they will go for. Sole proprietorships and partnerships are seen as an easy, inexpensive, uncomplicated, and convenient option. However, running your startup as a limited liability company (LLC) from the get-go has plenty of compelling advantages.
When your startup is operating as a partnership or sole proprietorship, you and the business are, in many respects, synonymous. You are personally liable for contracts signed, loans taken and lines of credit extended. If the startup runs into legal trouble such as a customer lawsuit or a creditor’s recovery action, your personal assets are at risk.
With an LLC, the founders/owners are protected against personal liability. There’s a wall separating your personal assets from business liabilities. As long as the business adheres to all the requisite corporate laws, court judgments cannot attach your personal belongings to recover company liabilities.
2.Mitigate Against Partner/Founder Fallout
When a startup is formed by two or more people, the early days are often rosy and characterized by great camaraderie. The majority of startups with more than one founder are based on a strong friendship. Things, however, don’t necessarily remain so buddy-buddy once the business takes off.
Disagreements, misunderstandings, and conflicts may set in as each co-founder stands their ground over what direction the startup should take. By forming an LLC that clearly defines how equity is split, you reduce the risk of a calamitous chaotic fallout during the internal conflict. Decisions and splits would be dictated by the formal, clearly-spelled-out paperwork of the LLC.
Startups may have big dreams, but they are often cash-strapped. And without cash, you have to get a little creative if you want to get things done. Stock options are a powerful tool for startups to use in this regard.
With an LLC, you can use options to compensate employees and contractors in lieu of cash. It’s certainly possible for you to draft a pre-incorporation legal agreement granting a third party equity in the business after incorporation. Still, it’s much easier to do this by forming an LLC first then proceeding to offer stock options.
In the beginning, hardly anyone knows your startup. Your business doesn’t have the name recognition that would effortlessly open doors anywhere you go. No matter what business structure you opt for, it’s going to take at least months, but more likely years, before that happens.
That being said, forming an LLC will give your business much more credibility from the start than you would have as a sole proprietorship. An LLC demonstrates a long-term commitment to the cause. In fact, some industries and organizations will not award a contract to a bidder who submits a proposal as a sole proprietorship or partnership.
In certain cases, the corporate tax rate is lower than personal tax rates. LLCs may, in addition, be eligible for other tax deductions and benefits that individuals do not qualify for. Many sole proprietorships convert to an LLC as a means of lowering their self-employment taxes.
Actual tax savings will vary on a case by case basis. Liaise with a tax attorney or tax accountant for a more specific look at your own circumstances.
An LLC is not a business structure reserved for big businesses. Startups can enjoy these advantages by forming an LLC early. There are certainly extra obligations that come with being an LLC, but the benefits outweigh the drawbacks in most cases.