S&W Startup Series Choice of Legal Entity December 11, 2014

Ben Armour, Corporate barmour@sandw.com (617) 338-2423

Brian Hammell, Tax bhammell@sandw.com (617) 338-2462

Agenda

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Reasons to Form a Legal Entity Why Can’t I Just Use LegalZoom? Basic Assumptions Common Types of Legal Entities

› Characteristics › Method, Cost and Ease of Formation

How to Decide Which Entity to Choose Changing Legal Entities

Reasons to Form a Legal Entity

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Potential to Reduce Personal Liability

Potential to Establish Credibility

Provides Tax Flexibility

Facilitates Management and Control

Why Can’t I Just Use LegalZoom?

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Why Can’t I Just Use LegalZoom?

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Why Can’t I Just Use LegalZoom?

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Why Can’t I Just Use LegalZoom?

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Internet is Slow Generally-Available Forms are not Customized Limited and Incomplete Explanations

Basic Assumptions

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Founders will want to pursue the “Silicon Valley model” › Angel › Venture Capital › Family Funds

Founders will want to be a target in an M&A transaction › Strategic › Portfolio › Acqui-hire

Founders will want to take the company public Founders will not want to run a “family business” for

decades

Common Types of Legal Entities Characteristics

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Sole Proprietorship

Partnership › General Partnership › Limited Partnership

Corporation › C Corporation › S Corporation

Limited Liability Company

Sole Proprietorship Characteristics

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Default Liability

› Unlimited personal liability for business debts can be mitigated through procuring insurance

Credibility › Few formalities could make a sole proprietorship appear

unsophisticated

Tax Consequences › Business is not a separate entity for tax purposes; income is taxed to

sole proprietor

Management and Control › Sole proprietor has autonomy › Business terminates upon sole proprietor’s death; no ownership

transfer

General Partnership Characteristics

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Organization › Two or more parties who voluntarily agree to own and run a for-profit business

in which they equally share management duties and profits or losses

Liability › Unlimited personal liability

Credibility › Partnership Agreement lends some level of sophistication

Tax Consequences › “Pass-Through” tax treatment available

Management and Control › Equal right of each partner to manage the business; simple majorities usually

prevail

Profits and Losses › General Partners share equally (unless otherwise agreed)

Limited Partnership Characteristics

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Organization › At least one General Partner (who provides capital and manages the business)

and one or more Limited Partners (who provide only capital)

Liability › General Partners have unlimited personal liability; Limited Partners risk only

their capital contributions

Credibility › Partnership Agreement lends some level of sophistication

Tax Consequences › “Pass-Through” tax treatment available

Management and Control › Equal right of each General Partner to manage the business; Limited Partners do

not manage the business

Profits and Losses › Usually shared based upon the value or percentage of each partner’s capital

contributions to the business

Corporation Characteristics

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Organization › Formed by one or more parties under state law

Liability › Limited liability for shareholders

Credibility › Well-recognized, well-respected; preferred form of entity for VCs

Tax Consequences › C Corporation: Double taxation › S Corporation: “Pass-Through” Taxation

Management and Control › Shareholders, directors and officers

C Corporation vs. S Corporation Characteristics

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Organization › S Corporation has 100-shareholder limit › S Corporation shareholders must be U.S. citizens or residents

Tax Consequences › S Corporation: “Pass-Through” Taxation › Corporation does not pay taxes; each shareholder will receive a Form K-1

reporting the business’s income to such shareholder as a result of the investment

Management and Control › Corporation must elect S Corporation status with the IRS

Profits and Losses › C Corporation: no pressure to distribute cash to cover taxable income › S Corporation: generally S Corporation shareholders can use losses, deductions,

credits and other tax benefit items from the business to offset other income on their individual tax returns

Limited Liability Company Characteristics

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Organization › Formed by one or more parties under state law

Liability › Limited liability for members

Credibility › Well-recognized, well-respected; not a favorite of VCs

Tax Consequences › “Pass-Through” Taxation

Management and Control › Single-Member LLC is easy (LegalZoom is okay!) › Members, managers or directors, and officers

Common Types of Legal Entities Method, Cost and Ease of Formation

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Sole Proprietorship: easy and cheap › Default; no formation action required (i.e., no filings) › Obtain licenses and permits; obtain EIN if there are employees › Must pay self-employment tax on your own income

General Partnership: moderately easy and cheap › No formation action required (i.e., no filings) › Obtain licenses, permits and EIN › Must pay self-employment tax on your own income › Partnership Agreement recommended

Limited Partnership: moderately easy and cheap › No formation action required (i.e., no filings) › Obtain licenses, permits and EIN › Must pay self-employment tax on your own income › Partnership Agreement recommended

Common Types of Legal Entities [cont’d] Method, Cost and Ease of Formation

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C Corporation: Goldilocks › Prepare and file Articles of Organization › Filing fees, annual report filing fees, annual corporate excise tax

[aggregate minimum of approximately $1,000] › Obtain licenses, permits, EIN › Must follow corporate formalities

S Corporation › Same corporate formalities as for a C Corporation › Must file Form 2553 to elect S Corporation status

Limited Liability Company: Difficult and Expensive › Prepare and file Certificate of Organization › Filing fees, annual report filing fees [aggregate minimum of approximately

$1,000] › Prepare a Limited Liability Company Agreement › Obtain licenses, permits, EIN

How to Decide

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Not Viable: Sole Proprietorships › Too much liability › Not enough credibility › Limited access to capital

Not Viable: General Partnerships and Limited Partnerships › Unlimited liability for general partnerships › Difficulty transferring ownership › Partners bound by law of agency › Limited access to capital

How to Decide [cont’d] Formalities

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C Corporation: › (-) adherence to corporate formalities

S Corporation: › (-) adherence to corporate formalities

Limited Liability Company: › (+) fewer organizational formalities › (+) operating agreement governs all issue with regard to LLC

Formalities Conclusion: › After the initial formation, LLCs are generally easier to operate than Corporations

How to Decide [cont’d] Taxation

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C Corporation: › (-) double level of taxation › (-) taxable event when distributing appreciated property from entity › (+) no Form K-1 for stockholders

S Corporation: › (+) one level of taxation at stockholder level › (-) taxable event when distributing appreciated property from entity › (-) stockholders taxed on company’s income and must complete a Form K-1

Limited Liability Company: › (+) one level of taxation at member level › (+) can generally distribute appreciated property without triggering gain › (-) members taxed on company’s income and must complete a Form K-1

Taxation Conclusion: a consideration but not the key consideration › Applicable only when C Corporation makes distributions, or dividends, of

earnings and profits to shareholders › A C Corporation that is not generating a lot of cash will likely not be in the

position of making distributions › BUT, some VCs might not be interested in LLCs because of the Form K-1

requirement

How to Decide [cont’d] Loss Pass-Through

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C Corporation: › (-) no pass-through of losses

S Corporation: › (+) generally, losses, deductions, credits and other tax benefit items may offset

other income on individual tax returns

Limited Liability Company: › (+) generally, losses, deductions, credits and other tax benefit items may offset

other income on individual tax returns

Loss Pass-Through Conclusion: › S Corporation and LLC form of entity are preferable if loss pass-through is a key

factor, but loss pass-through is unlikely to be a key factor › BUT, VCs might prefer limits on loss pass-through

How to Decide [cont’d] VC Appeal

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C Corporation: › (+) can issue convertible preferred stock (i.e., multiple classes of stock), the

typical vehicle for venture capital investment

S Corporation: › (+/-) will automatically convert to a C Corporation if receives VC investment

Limited Liability Company: › (+) can issue multiple classes of stock › (-) VCs typically will not invest in LLCs and may be precluded from doing so under

various VC fund documents

VC Appeal Conclusion: › C Corporation form of entity is the path of least resistance in terms of VC Appeal,

but VC funding is difficult to obtain and may take at least one year

How to Decide [cont’d] Reinvestment of Capital

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C Corporation: › (+) can retain operating capital without pressure from stockholders

S Corporation: › (-) pass-through taxation may make conservation of operating capital difficult

because S Corporations typically must distribute cash to enable stockholders to pay taxes on pro rata share of S Corporation’s income

Limited Liability Company: › (-) pass-through taxation may make conservation of operating capital difficult

because LLCs typically must distribute cash to enable members to pay taxes on pro rata share of LLC’s income

Reinvestment of Capital Conclusion: › C Corporations are generally better if conservation of capital is a key factor

How to Decide [cont’d] Equity Compensation

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C Corporation: › (+) can issue traditional stock options and incentive stock options

S Corporation: › (+) can adopt traditional stock option plans and can issue incentive stock options

Limited Liability Company: › (-) difficult for LLCs to issue stock options, and incentive stock options are not

available

Equity Compensation Conclusion: › C Corporations and S Corporations provide more flexibility from an equity

compensation perspective

Bonus: Fringe Benefits › C Corporations and S Corporations have more favorable treatment of fringe

benefits

How to Decide [cont’d] Raising Equity, Going Public

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C Corporation: › (+) can engage in traditional equity financings

S Corporation: › (+) can easily engage in equity sales; does not have to convert to a corporation to

issue equity

Limited Liability Company: › (-) complicated to sell equity or go public; as a practical matter, LLC needs to

transfer its assets to a new corporation, merge with a new corporation, or engage in a state law conversion before entering the public equity markets

Going Public Conclusion: › C Corporations and S Corporations have more favorable paths to going public

Changing Legal Entities

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Converting to a C Corporation: › S Corporation: easy to convert to a C Corporation; automatic conversion after

accepting VC money › LLC: must transfer its assets to a new corporation, merge with a new

corporation, or engage in a state law conversion › LLC: may raise issues relating to conversions of capital accounts into

proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents

Thank You

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Key Contacts › Ben Armour, Corporate

barmour@sandw.com (617) 338-2423

› Brian Hammell, Tax bhammell@sandw.com (617) 338-2462

› Kristen Young, Corporate kyoung@sandw.com (617) 338-2427