Common Mistakes Startup Founder Make when FORMING a Company | Startup Legal Advisor, Michael Hool

All right, so in the forming stage, forget about number 1, enough said about that. The type of entity is probably one of the first things you'll be wrestling with, and there's not a lot to wrestle with sometimes, but your choices essentially are in the United States, again, if you're domiciling an entity here. It's going to be either a limited liability company or a corporation. a C corporation. And a corporation, a C corporation just means that's, it's the section of the IRS, Internal Revenue Service code that the corporation is kind of the way it's treated. I did some research last year for something and I looked at some data and the, what I found out was from the, I think this was from the Kauffman Foundation, In the United States, just shy of 70% of all startups were LLCs. So it's common, it's easy, it's in all 50 states now. There's a lot of reasons that people form LLCs. But just recognize that that's kind of conventional wisdom across the United States. However, In Silicon Valley, it's flipped. It's roughly 70% C corporations. And for the— I'd say 90% of that 70% is probably Delaware C corporations. And why is that? Well, it's number one, you have a lot of tech startups here that are high growth. And there's a lot of reasons eventually that you would want to be a C corp. But the other is the influence of venture capital, institutional venture capital. Yeah. I have hosted panels of venture capitalists in Phoenix annually for the last 12 years. There's roughly 6 VCs on the panel at a time. I always ask this question just because the audience tends to have these questions. I say, do you invest in LLCs? Or do you require them to be C-corps? In that whole time, of all the panelists, I've only had one that said LLCs. Everybody else, 99.9%, C-corps. The reason is, there's a lot of reasons why you would want to be a C versus— a C-corp versus an LLC, but institutional investors that are raising money from other people, They have partners that have limitations on the types of entities they can invest in. Most VCs, larger VCs that raise money from institutions that aren't humans, that aren't high net worth individuals, like in California, the state pension funds, there's different insurance companies, there's different tax-exempt type entities. There's a lot of issues about— they can't be part of a fund that invests in LLCs. So just recognize that. If you're going to be creating a business that you will be raising money from VCs, just know that at some point you're going to have to be a Delaware C corporation. And when— by the way, I'm going to just kind of buzz through these and Half in a little over half the time that we have, and I'm going to open up for questions. So I do want you to kind of dig in on any of these things. So because I'm not going to drill down too much on on any particular one. Do you guys know the differences? I mean, an LLC basically is it's a limited liability company, and it's a creature of partnership law. So it's it's a every state has them now. Started in Wyoming. I don't know seventeen years ago or twenty years ago. Something like that. And it was really a way to create a partnership structure that has limited liability for the owners. So you can't get sued for the business credit— by the business creditors. When I say it's a creature of partnership, that's important because partnerships are really, you know, you think about it, you're a partner with somebody and the law is designed around the notion that You should never be forced to be a partner with somebody you don't want to be a partner with. And that has one significant consequence. That is, by comparison, a corporation, you have shares of stock in the company, and you basically have 2 rights as a shareholder. One is your economic rights. You know, if this thing goes up in value, I can sell it. If there's dividends or whatever, I have the right to receive those. But the other is voting power. So with shares of common stock of a corporation, when you transfer that certificate, both of those rights transfer. Okay. In a limited liability company like a partnership, the only right that transfers is the economic rights. So unless you have an agreement by all the members or you have an operating agreement that pre-approves admission of whoever the transferee is. The person, the transferee of the interest does not have any power. They don't have any voting rights. That's important to understand just because a lot of what you do involves planning at the early stages around how do we tie up our ownership interests among the founders to make sure that, you know, we don't end up having somebody's spouse or you know, somebody's mother as my partner in the business when that person, you know, becomes disabled or something like that. So in terms of just to distill on this choice of entity, corporate versus LLC, if you're going to be raising money from institutional types or if you are going to be generating profits, sometime in the near future, you probably will become a C corp. So the default would be if you're going to be a high-growth company, at some point you're going to be a C corp. Now, I have a lot of clients and we do a lot of planning with LLCs. You can set up an LLC to mirror largely how a corporation works. What you want to be careful of is because an LLC is taxed as a partnership, LLCs will at the end of the— let's say the company earns $100 and you have 3 partners. And just assume for right now it's all, you know, 1/3, 1/3, 1/3. At the end of the year, the LLC will not pay any taxes on that $100. What happens is you'll get what's called a K-1. It's a form. It's a 1040. a tax form. Every owner, every partner will get this form and it'll say that you've earned $33 1/3 for— so the entity doesn't get it. It passes through and all the owners are the ones that get taxed on that. Well, what's the problem with that? The problem with that is for most high fast-growing companies, they need the money, any profits that are generated to keep growing the company. They're not making distributions. Frankly, just because they might have a profit, they may not even have any cash. They may have already spent it. So it creates kind of a problem for owners, and that's why investors generally, when you start making profits, are not too happy about LLCs because they're going to get reported income on money that they didn't receive and they're going to have to pay taxes on it. So you got to work out a mechanism within the company to start making regular distributions To your owners to pay taxes. I have a few clients right now that, you know, they're not really going to go for venture. They just took off and they are generating a lot of money now. But they're wrestling with this problem. It's like we want to keep the money in the company and we don't want to be paying it out to the owners to pay their taxes. So we're probably going to convert them into a C corp. Corporation, on the other hand, when the money comes in, If that $100 is truly profit, the corporation pays the tax. But you don't have to distribute anything. So the tax gets paid somewhere, either at the corporate level or the individual level. You might as well, if you're high growth and you're going to need the money to fund the operations, it's just a lot easier to do it within the corporate entity. There's a lot of things we could talk about in choice of entity. I'll save that for questions. On the regulatory environment, I'll give you a couple examples. I had a startup that was one of the early people in the space for lending through the internet, these big lending networks. Now there's a lot of them, and they're doing incredible— some of them are doing incredibly well. It's the efficiency of the internet marketplace. The challenge that they had was the regulatory environment around consumer lending is hugely regulated, and it varies a lot from state to state. Think about it. You have an internet business, and you're making loans to consumers, mostly microloans, and every state has different rules about how you can conduct business there, whether you have to be licensed, all kinds of special rules. Well, that's a huge issue for that type of a company. They generally knew about it, but they didn't have any money to look into it and figure out everything. So they were kind of behind, before their time. But that's an example. You need to know, like, if you're going to be in any environment where there's regulation, Definitely know that as early as possible in advance. You guys probably have seen Shark Tank a bunch of times. I just love it when someone will ask the question, well, isn't that regulated? And someone's face will just go, uh, and they'll turn all white. And it's like, yeah, but we're looking into that. Well, that just means you're not getting any money from that investor. Because if you haven't figured it out, they don't want you spending the money to do research to find out you can't do something. under your business model. Another one I had was in telemedicine. Early— this was like, you know, very early in the '90s where it was new. The internet was just kind of changing everything. And you think about it, the practice of medicine is regulated in every state. Every physician gets licensed in their own state. And there were— again, it was a similar thing, rules all over the place. And they kept running up against this issue of all these rules. And it would be very expensive. They ended up getting funding in 3 different tranches from Johnson Johnson. But they pivoted in their business model because of this regulatory issue where they just moved into teaching in the hospitals where they could watch surgeries live and stuff remotely. And selling pharmaceutical products through the network once they were into the hospitals. Well, that became their business because practicing medicine remotely back then, the laws weren't really as good as they are now and it wasn't as easy. It was very difficult to do. Johnson Johnson ended up buying the company just so they could sell pharmaceutical products through their network. Anyway, but that's the point. You gotta understand like the scope and if you're in a regulatory environment, you gotta know it. Thank you.