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How to Build a Company: Part 1 - Business Entity Types

How to Build a Company: Part 1 – Business Entity Types

I have started over a dozen businesses throughout my career.  Some successful and some “learning experiences.”  I am fortunate that more have succeeded than failed.  I try to pay it forward for the blessed life I have had by helping others learn from my mistakes and benefit from my experiences.  I coach young Entrepreneurs every chance I get.  I am proud to see many of them grow to create successful businesses of their own.

One of the questions I frequently get when talking to people thinking about starting a business is, “do I really need to form a Company?”  After answering yes with zero hesitation, I usually get the deer in the headlights look.  With that WHY? look in their eyes.  Establishing a company and dealing with lawyers, accountants, taxes, forms, annual board meetings, etc. isn’t generally the first thing that someone wants to do.  I thought I’d write a series on what forming a company actually means.  This first post in the series will discuss different business entity types.

Sole Proprietor and Partnerships

One of the key reasons for a new business venture to establish a formal entity out of the gate is to insulate the founder(s) form liability.  Anyone can start doing business as themselves, but that comes with significant risk that isn’t always understood.  As a Sole Proprietor, one who is in business for themselves, the principal owner is 100% at risk for everything they do.  If they have an employee that drops a box on a customer, the Owner/Sole Proprietor is personally on the hook for damages.  Every personal homeowner, auto, and umbrella policy I’ve seen has exceptions that exclude professional coverage.  In other words, if you are sued for doing work for a business you own…your personal insurance likely will not cover you.  Simply hauling boxes in your car to a clients house could result in no insurance and policy cancellation if you are in an accident (even one not your fault). Employees with a grievance can sue for a multitude of issues that could wipe out a Sole Proprietor’s personal assets even if the petitioner doesn’t win the case. 

NOTE: The personal liability issue also holds true for the small multi-level marketing businesses such as Amway, Mary Kay Cosmetics, Herbalife, etc. as well.  The people selling those products, recruiting others, etc. are typically operating as Sole Proprietors and could be personally held liable by an unhappy customer or recruit.  

A side note on personal liability and insurance is the emerging “shared economy” business models such as Uber and AirBNB.  When one starts driving for Uber, as an example, they are in the gray area of commercial vs individual operations.  Uber covers a driver and passenger liability and the vehicle (with restrictions) under their commercial policy as long as a paying passenger is in the car or the driver is on the way to pick up the passenger (e.g. they have accepted the trip on the Uber app).  However, when the driver is waiting for the next assignment they are doing so under their personal Insurance policy.  Uber will cover a loss with state minimum coverage in some cases if the main insurance doesn’t, but an accent regardless of what sage of a trip the driver is in often leads to policy cancellation putting them on the high-risk list.  

Geico and other carriers are starting to offer Hybrid personal/commercial policies for drivers that is significantly more expensive (read: Geico Ridesharing Insurance FAQs)

Accordingly, when one lists their home through services such as AirBNB, they turn their private residence into a rental.  Most personal homeowner polices do not cover commercial operations such as rentals.  When operating either of these business types the person and/or property/vehicle owners are considered Sole Proprietors or Partnerships when the asset is co-owned.

Similar to a Sole Proprietor business, a Partnership is a company formed by two or more people.  The only difference from a liability perspective is that all owners are equally liable for business damages and losses.  For example, one partner could file bankruptcy leaving the other 100% responsible for all debts and liabilities.  A Partnership is not an equal split either.  One partner could be silent with minimal direct interaction with daily operations while the other could be fully engaged, yet when liability is handed out the person who has the most assets ends up being responsible. The percentage of involvement in the business has zero effect on liability in a partnership.

Partnerships and LLP’s

Partnerships come in all shapes and sizes, but if a partnership is what one wants then we have to look no further than the legal profession.  Most Law firms are LLP’s, which stands for Limited Liability Partnership.  LLP’s are unique in that there are legal protections that cover the owners (states have different laws though). LLP’s are considered a General Partnership arrangement, which basically means that every partner has an equal say in how the business is ran.  It is management by committee.  When there is a stalemate then effectively the hold-out wins since decisions can only be acted on when voted in favor by the majority.  It tends to be best to form partnerships with an odd number (3, 5, 7, 9) of partners to prevent situations such as this from occurring.

Another potential downside with both partnerships and LLP’s is that you can’t simply leave the group.  In the case of a traditional Partnership the Business would have to be dissolved if a partner leaves or dies.   A partner cannot transfer or sale their portion in a traditional partnership.  An LLP is somewhat different in that partners can be added or removed, but a majority vote of the remaining members must pass to permit a change.  The remaining group may actually decide they do not like someone a partner is trying to sell their partnership to and deny the transaction.  Liabilities and profits are also equally spread over all partners.  If the business has a loss, the partners are responsible to settle the debts every year.  They are also personally liable for their portion of a business profits.

Limited Liability Company or LLC

A LLC is a form of a Incorporation (Inc.) I will discuss shortly.  LLC’s are similar to a partnership where individuals can buy into ownership, but the main difference is that there can be levels of shares that can equate to voting rights  One person in an LLC could own 51% of the shares and bring in others while maintaining control over the Business.  Similar to LLP’s, profits and losses are generally spread across the owners based on the percentage they own of the Business.  The prorated gains or losses are incorporated into each owners personal tax return.  Depending on the success of a company and the wealth of each individual owner, however, the income tax liability may be significant.  Individuals are generally taxed at a higher rate than a standard Corporation.

Another key advantage of forming an LLC is that some states, including Delaware, have laws that enable an LLC to be single entity formed.  This means an individual, or another Company type, can create a LLC without any additional owners.  A LLP requires at least two named partners.  The advantage of a single-entity LLC is that this enables the business to be formed, bank accounts opened, leases signed, etc. by the business in preparation to bring in investors, customers, and/or other owners after the company has started operations.  Individual Entrepreneurs can create a business on their own to incubate and then go to market with a working business, which will have more value than an idea on paper.

I’m not a tax attorney, so I highly recommend seeking professional advice when it comes to taxes.  It has been my experience that it is best to form an LLC and change its tax classification to a Corporation.  There are tax forms that need to be filed for this to happen…again talk to a tax professional…  When an LLC is taxed as a corporation it then files and pays its own taxes.  Moneys paid out to shareholders are paid in the form of dividends that are carried on the shareholders personal income tax returns.  In certain situations, however, a corporation classification for an LLC can lead to being double taxed — the business pays for its income then the owners are subsequently taxed on their dividends, etc.  Shareholders can get hit with capital gains if the company is successful and they sell their shares or the business as well.

Standard Corporations (a.k.a. Inc.)

Typically when we talk about a Company we are talking about the Incorporation or what we see in many business names as Inc.  An Inc. is an entity of its own in the eyes of the taxing systems and can have a virtually unlimited amount of shareholders, stock classifications, etc.  When we see US businesses being publicly traded they are generally an Inc.  Other country’s have similar classifications that go by different names.  In the UK, for example, they have a company definition as a PLC (Public Limited Company), which is basically the same as an Inc. in the states.

Inc’s have a big advantage when it comes to raising funds while maintaining control.  A business could release millions of shares while the principals continue to maintain control over the business.  Walgreens Alliance Boots (NASDAQ: WBA) is a good example.  Stefano Pessina is the primary investor that owns approximately 45% of the publicly traded Company.  He effectively has implicit control over the $130-Billion per year business with billions in assets.  Mr. Pessina along with any other other investor that owns 5.1% or more of the Company makes the final decision on what the Company will do.  Shareholder meetings, voting rights, etc. have no material impact on how the Company is operated.

Inc’s have many advantages, but as an entity in their own right traditional Company formations are fully tax burdened.  The Company is responsible for its own income taxes and any financial distributions to shareholders, investors, etc. are fully taxed.  I generally do not recommend starting an Inc. unless a Business is clearly on the IPO track bringing in multiple stages of funding or has plans to raise money through a significant number of investors (e.g. Penny Stock or GoFundMe investors that acquire ownership in a business).

Although it can be a complicated transition that could require back-filing of taxes, ownership structure may be changed in the future if necessary.  At Orbitz, for example, we started the company as DUNC, LLC in Delaware when the airlines (Delta, United, Northwest and Continental) were the sole owners of the Company.  After the LLC formation the airline owners subsequently added American Airlines to the LLC.  We later formed Orbitz Inc. when we were preparing to go public.

Summary

Hopefully I have helped bring clarity to this confusing topic.   The main decision can be boiled down to asking a couple of questions.  Are you creating a partnership that will have equal voting rights for everyone or do you want different levels of ownership?  In general terms, if you want everyone to be equal form an LLP.  If ownership levels are needed, the principal founder(s) want to maintain majority control, a single individual needs to start the initial business, etc. form an LLC.  However, if you expect to be brining in a large number of investors through penny stock sales and other means that would require SEC oversight then form an Inc.

Chicago CIO and Entrepreneur. Started @Orbitz, @AssureFlight, Team ITG, YourPrivateLine and others. I Love technology, startups and meeting interesting people.