How To Define a Corporate Structure for Startups

How To Define a Corporate Structure for Start-ups: What, Why, Where, & How? Gary M. Myles, Ph. D. Mark P. Walters Intellectual Property Attorneys & Members Lowe Graham Jones PLLC November 5, 2015

How to Define a Corporate Structure for Start-ups • "A well-defined corporate and organizational structure is key to attracting investors" • Topics for Discussion § § WHAT: Overview of Business Entities • Legal, Tax, and Liability Considerations WHY: Choosing the Best Business Entity • Ensuring Successful Business Transactions • Financing, Partnering, M&A, IPO § HOW: Logistics of Incorporation

Choice of Business Entity • Sole Proprietorship • General Partnership • Limited Liability Company • Corporation § § S-Corp C-Corp

• Definition: § WHAT? Sole Proprietorship Business entity in which all assets are owned by one person • Management: § Management and operation decisions are wholly in the control of the owner • Liability: § Owner is personally liable for all business liabilities • Tax Treatment: § § Income and loss are recognized by the owner directly on his or her personal tax return No separate entity tax return required

HOW? Sole Proprietorship • Formation: § § No governing statute No legal formation requirements File master business application with Washington Business Licensing Service (http: //bls. dor. wa. gov/) Acquire employer identification number (EIN) from IRS (https: //www. irs. gov/Businesses/Small-Businesses-&Self-Employed/Employer-ID-Numbers-EINs)

WHY? Sole Proprietorship Pros: • Simple and cheap • No legal formation requirements • No non-tax record keeping • Single level of taxation Cons: • Unlimited personal liability • Co-owners prohibited • Business ceases with owner’s death

Choice of Business Entity • Sole Proprietorship • General Partnership • Limited Liability Company • Corporation § § S-Corp C-Corp

WHAT? General Partnership • Definition: § An association of two or more persons to carry on as co -owners a business for profit • Intent to form a partnership is not necessary • Sharing in profits evidences partnership • Management: § Vested in the partners, unless specifically delegated to one or more partners • Delegation of management does not limit a partner's liability for the obligations of the partnership

WHAT? General Partnership • Liability: § § Each partner has joint and several liability for • His or her acts and the acts of the other partners • Debts and obligations of the business A partner is not liable for obligations of the partnership incurred before the partner's admission to the partnership

WHAT? General Partnership • Tax Treatment: § A general partnership is a flow through entity • No entity level taxation • Income and loss are reported and recognized by the partners on their personal tax returns • Cash distributions of the partnership are taxable if they exceed a partner's tax basis in his or her partnership interest • A federal partnership tax return must be filed

WHAT? General Partnership • Costs: § Limited formation and maintenance costs • Transferability of Interest: § § A partner's economic interest is transferable A partner’s right to manage the partnership or vote are not transferable unless … • all partners consent, or • provided by the Partnership Agreement

HOW? General Partnership • Formation: § § Governed by the Uniform Partnership Act (RCW 25. 05 http: //apps. leg. wa. gov/RCW/) A Partnership Agreement setting forth terms of ownership, voting rights, distribution of profits, ability to transfer interests, dissolution -- not required but recommended

WHY? General Partnership Pros: • Simple and cheap. • No non-tax recordkeeping requirements • Can allocate profits and losses specially among the partners • Single level of taxation • Practical where liability is minimal Cons: • Partners have unlimited personal liability • Problems inherent in shared management responsibility

Choice of Business Entity • Sole Proprietorship • General Partnership • Limited Liability Company • Corporation § § S-Corp C-Corp

WHAT? Limited Partnership • Definition: § A partnership comprising • one or more general partners who manage [the] business and who are personally liable for partnership debts, and • one or more limited partners who contribute capital and share in profits but who take no part in running [the] business and incur no liability with respect to partnership obligations beyond contribution

WHAT? Limited Partnership • Tax Treatment: § § § A flow through entity Income and loss are reported and recognized by the partners on their personal tax returns A federal tax return must be filed by the partnership

WHAT? Limited Partnership • Liability: § § General Partner • Unlimited personal liability for the obligations of the partnership Limited Partner ("silent partners”) • Liability is limited to the extent of his or her capital contribution to the partnership • A limited partner who participates in the management of the partnership may lose his or her limited liability protection

HOW? Limited Partnership • Formation: § Formed by filing a Certificate of Limited Partnership with the Secretary of State (http: //www. secstate. wa. gov/_assets/corps/LPCERT. pdf) § § Partnership Agreement not required by statute, but is highly recommended Partners can be individual persons or entities

WHY? Limited Partnership Pros: Cons: • General partner retains control of partnership • General partners have unlimited personal liability • Limited partners have limited liability • Limited partners may lose limited liability protection if they participate in management and control of the partnership • Capital structures are more flexible than general parnerships • Single level of taxation

CHOICE OF BUSINESS ENTITY • Sole Proprietorship • General Partnership • Limited Liability Company • Corporation § § S-Corp C-Corp

WHAT? Limited Liability Partnership • Definition: § § A partnership that files a statement of qualification of registration as a limited liability partnership according to state law Elements of both partnerships and corporations • Limited liability is analogous to liability of corporate shareholders • Unlike corporate shareholders, LLP partners can directly manage the business

WHAT? Limited Liability Partnership • Tax Treatment: § § § A flow through entity Income and loss are reported and recognized by the partners on their personal tax returns A federal LLP tax return must be filed by the partnership

WHAT? Limited Liability Partnership • Liability: § § Generally, a partner is not liable for acts or omissions of other partners (“full-shield liability”) In some states, a partner is liable for the debts of the LLP and for acts or persons under the partner’s direct supervision and control (“partial-shield liability”)

WHAT? Limited Liability Partnership • Transferability: § § A partner’s economic interest in an LLP is transferable A partner’s right to manage/vote is subject to a LLP Agreement and state law

HOW? Limited Liability Partnership • Formation: § Formed by filing a Certificate of Limited Liability Partnership with the Secretary of State (http: //www. sos. wa. gov/_assets/corps/forms/LLP_Reg 2015. pdf) § § Partnership Agreement not required by statute, but is highly recommended Partners can be individual persons or entities

WHY? Limited Liability Partnership Pros: • High level of flexibility and control • Limited liability protection • Commonly used entity for accountants and lawyers • Single level of taxation Cons: • Limited liability protection vulnerable to application of “piercing the corporate veil” theories • Formality and expense similar to LLCs • Uncertainty owing to under-developed case law

CHOICE OF BUSINESS ENTITY • Sole Proprietorship • General Partnership • Limited Liability Company • Corporation § § S-Corp C-Corp

WHAT? Limited Liability Company • Definition: § § A company that is characterized by • Limited liability • Management by members or managers • Limitation on ownership transfer Ownership interests (i. e. , “membership interests”) are held by members of the company • Management: § Management of an LLC may vest in its members or in a member or non-member manager

WHAT? Limited Liability Company • Tax Treatment: § § § LLCs can be treated as partnerships for federal income tax purposes thereby avoiding taxation as a corporation (i. e. single vs. double taxation) LLCs may elect to be treated as corporations for federal tax purposes If an LLC has operations in multiple states, its state to state tax treatment may vary

WHAT? Limited Liability Company • Liability: § § § Members of an LLC enjoy limited liability protection Liability of managers is limited by statute absent a breach of fiduciary duty Limited liability protection may, however, be negated by “piercing the corporate veil” theories

WHAT? Limited Liability Company • Transferability: § § A member’s economic interest in an LLC is transferable A member’s right to manage/vote is subject to a LLC Operating Agreement and state law

HOW? Limited Liability Company • Formation: § Formed according to state statute by filing a Certificate of Formation with the Secretary of State (http: //www. sos. wa. gov/_assets/corps/forms/LLC_Formation 2011. pdf) § The LLC and its members execute an Operating Agreement (i. e. , LLC agreement) setting forth the agreement of the members as to the management of the affairs of the LLC and the conduct of its business

WHY? Limited Liability Company Pros: Cons: • Members enjoy limited liability protection • Uncertainty owing to under-developed case law • Flexible capital structure • State to state variability in LLC statutes § § § May have different classes of membership interests Admission to membership without a capital contribution Membership interests without economic interests • Fewer statutory formalities than for corporations • Partnership tax treatment

CHOICE OF BUSINESS ENTITY • Sole Proprietorship • General Partnership • Limited Liability Company • Corporation § § S-Corp C-Corp

WHAT? Corporation • Definition: § A legal entity that is formed under state law and in which ownership interest (i. e. , stock) is owned by one or more shareholders • Management: § § § Corporations have centralized management that is vested in a board of directors and company officers The board of directors is elected by the shareholders Officers are appointed by the board of directors

WHAT? S Corporation • Tax Treatment: § § A corporation electing to be taxed under Subchapter S of the Internal Revenue Code S corporations are flow-through entities and are taxed like partnerships thereby avoiding double taxation S corporations must file federal corporation tax returns S corporations have the following restrictions • No more than 100 shareholders • Shareholders must be individuals or trusts (NOT corporations or partnerships) • Shareholders may not be non-resident aliens • Limited to one class of stock, which can include both voting and non-voting common stock

WHAT? C Corporation • Tax Treatment: § § § A corporation taxed under Subchapter C of the Internal Revenue Code C corporations are subject to double taxation • Income of the corporation is taxable at the entity level and distributions to shareholders are taxable to the shareholders Election for Subchapter C treatment is NOT required

WHAT? Corporation • Liability: § § Shareholder liability is limited to the extent of his/her investment in the corporation unless a court “pierces the corporate veil” Limited liability protection and indemnification of corporate officers and directors unless they breach a fiduciary duty

WHAT? Corporation • Transferability: § Shares are freely transferable unless restricted by a Shareholder’s Agreement or under securities law

HOW? Corporation • Formation: § Formed according to state statute by filing Articles of Incorporation with the Secretary of State (http: //www. sos. wa. gov/_assets/corps/forms/Profit. Articles 2010 v 2. pdf ) § § § Must adopt by-laws addressing management and control of the corporation Must observe significant corporate formalities • Authorizing resolutions • Issuing shares • Subscription agreements • Preparing minutes of board and stockholder meetings • Maintaining books and records Must provide buy-sell arrangements and transfer restrictions in a Shareholder or Founder Agreement

WHY? Corporation Pros: Cons: • Shareholders enjoy limited liability protection • Double taxation with C corporations • Familiar corporate structure and well-developed juris prudence is appealing to investors and lenders • Significant and on-going formalities and filing requirements • Tax advantages in many liquidity transactions • Availability of incentive compensation (e. g. , stock options) • C corporations may have more than one class of stock § Appealing to venture capital transactions (i. e. , preferred stock) • Detailed and restrictive state corporation laws • Income and loss must be allocated in proportion to shares owned

Which Entity to Choose? • Primary choices § § § Limited Liability Company S corporation C corporation • Key Considerations § § How will your business be financed? • Self financed • Grants • Angel investment • Venture capital • Bank loans Substantial outside financing disfavors an LLC

Which Entity to Choose? C-Corp S-Corp LLC Pass-through Tax No Treatment Yes Flexible Ownership and Capital Structure High Low High Attractive to Investors Yes No No Complexity Moderate to High Costs Small to Moderate Small to High Ideal Profile VC or angel backed Early state intending to convert to a C corp Insubstantial outside investment Adapted from http: //wtnnews. com/articles/7526/

Incorporation in State of Principal Office or in Delaware? • Variability in State filing fees, taxes, and response times • Variability in extent of limited liability protection and indemnification of officers/directors • Variability in maturity of case law • Variability in favorability of regulations and business laws

Thank you!