Financing and market opportunity get all the attention in a business start up. However, an equally important question that needs to be addressed early on is the legal structure of the business. As early stage companies make life and death decisions pretty regularly, legal structure feels like one of those things to think about “when you have time”. This leads to the “common wisdom” of trying to start with the simplest structure possible, and then let it evolve with the company’s needs. A new study by the SBA indicates this evolutionary approach to business structure is a myth. Over the first four years of a business’ life less than 10% of companies make a change in their legal structure. By that time, many issues that should have been addressed earlier have turned from minor problems to major issues.
The reasons business structure is so important fall into two buckets – legal liability and taxes. I know very little about the legal liability bucket – it was too gross when I looked inside. My summary from the quick, unpleasant glance is that you get more protection from either a tightly crafted partnership agreement or a corporation, but you trade some flexibility for the protection. Think of it like wearing a bullet proof vest. If you need it, it’s worth the trouble, but it’s no fun to wear while you’re running a race. (This is another way of saying make sure to ask someone knowledgeable or you’ll really be in trouble.)
In terms of taxes, it’s essentially the opposite. A more complex company structure typically provides more tax flexibility. One unusual consideration related to tax payments and business structures is there’s a choice to be made about whether the business entity or the business owners pay the income taxes. The Cliffs Notes version of this very high level view is that typically capital intensive businesses are better off paying taxes. Generally, all others should let the participants pay the taxes, albeit ensuring these tax payers have taken steps to minimize those payments.
Notice how even at the most basic level this is already dense, headache inducing material. Unfortunately it really is worth taking some aspirin and getting clarity about areas of risk for your particular business that can be offset through structural decisions. Think of it as making sure the foundation on your house is done correctly. You wouldn’t wait until after it’s built to check…