LLC vs INC: a guide for startups

0:00 the single hardest thing about starting a business is that you have to make extremely impactful decisions too early in the game with honestly too little information and these are company defining decisions I'll give you $600,000 for it I'm prepared to give you $300,000 for 10% of your company okay 4 million 200,000 for 5% in a time when your brain is probably focused on building or bootstrapping or paying your bills not necessarily on paperwork or a legal structure that might not make any difference in the end the problem is though the legal structure you choose makes a huge difference in how your business might operate how it might grow or how it might be sold or even in how liable you or your investors are about the mistakes your company might make I went on this hunt for a simple plain English video that lets startup Founders

0:47 understand the type of structure that they need and I honestly could not find any you can even find hundreds of contradicting opinions online so I gave our legal team a call and I spoke to Legal firms inside and outside the US to understand how these different legal decisions and legal structures might affect you as a Founder in the short and the long term and here's the stuff that we're going to go through in this video first the basics of legal entities then understanding which entity works for the type of business that you're building the difference between stock and ownership raising funds or funding rounds with an LLC or a C Corp taxes on each type of entity and the common state and international exceptions big disclaimer this video will not touch on other types of entities because that's not what we put on the title not really because these are really the two most

1:33 common types of entities and we don't really want to over complicate it even more so here it is so why do we start companies let's start at the very beginning if you intend to sell something a product a service you probably want a legal entity for one of these three reasons one is because of liability protection in the US this entity provides a barrier between the owner of the company and the client the company can be sued and Americans love to sue people but the consequences of that will never extend to you as an individual or to the investors or to the executives unless there's fraud involved number two is taxes different legal entities are taxed differently but the point is that not all of the Alternatives will represent immediate personal income and then

2:18 finally because of agreements your agreements with your partners or your investors if you're working with someone on anything you need to agree on the rules of the game how do you share your profits how much how do you share your work money that different people injected into the business all of which will translate into percentage of business ownership and the simplest way to do that really is with a legal entity there are other smaller factors like credibility or maybe the ability to sign contracts as a company or to access Credit but those are very much secondary okay so the first thing that we need to understand now is the type of startup that you're building cuz the marketing agency the dev shop the dropshipping platform the new social media platform the new B2B SAS the AI tool they're all startups but not all of them are created equal some are venture vable meaning

3:03 that they can and probably must raise money from Venture capitalists to thrive and some are not they're smaller businesses that don't require large amounts of money to grow there's no heart rule on this but Venture back companies generally have a technology component something that's unique and proprietary they can generally scale very fast 100 plus million dollars in Revenue which means that they could be valued at billions of dollars in five maybe seven years generally they sell a product not services and generally they can operate with big profit margins again they're all startups we're going to call both of these startups but we like to make the distinction of calling the Venture bable kind startup and the other kind traditional business at least for the purpose of today's video we we actually have a whole video about that but that's for another day anyway only a

3:50 handful of companies fall into that ventor bable category so I'm actually going to leave that one for last so let's talk about a a traditional business story let's say that two friends got together to build an e-commerce platform and maybe they're going to sell what is that a cool slide cool slideing t-shirts grade no maybe they're selling I don't know they're selling T-shirts or board games or or blue candy there are two people in the equation so we can take that check we need a legal entity to agree on the ownership and establish rules in case someone leaves or dies rules on what percentage of the company each one gets rules on their responsibilities just with that we establish that a legal entity is need now e-commerce is Tech but it's not propri this candy business can probably make a few million dollars a year but unless the candy has some special Magic

4:35 Properties tight tight tight ja or unless this company becomes something like Amazon it won't be a billion doll company that means that it's unlikely to go through the VC funding path they might raise some money from a small investor or from friends or from family but this is not institutional capital and it'll probably be a single round of funding to get off the ground again this could happen later but it's unlikely most e-commerce companies don't raise institutional money now given these assumptions this company is much better off as an LLC because it plays to the advantages of an LLC so given this example these guys are selling this blue candy are they better off operating and as an LLC versus a C Corp is it a better option they're cover on liability they are cover on their partnership agreements but considering their business is smaller traditional they can

5:23 take advantage of the cheaper cost of operation of an LLC but the biggest Advantage for this company is actually taxes there's a good chance that they will want to collect the profits that the company's making each year and just share them split them and that's where one of the biggest advantages of llc's comes to shine for this example scenario these Partners can choose to be taxed as a partnership where the profits that the company makes are just passed directly based on their ownership level so it becomes personal income and then they pay taxes on at the personal level as part of their just annual income tax filings in the US on a C Corp on the other side the company must must pay first a federal corporate tax on all the company profits and if they then distribute profits to their shareholders they will be taxed again on their income

6:09 and this is known as a double tax process okay so let's go back to this why would anyone willingly want to be double tax of course nobody wants to be double taxed right uh but you will only be double taxed if this secorp makes a distribution of profit so C Corps could also be very efficient especially if distributions from the business buiness are not expect Year from year or in the short term if there's some sort of exit plan they could also be efficient there's a specific treatment whenever somebody transfer shares of a of a seet to someone else or stock of a seet to somewhere else they could be very efficient also if you have investors for for from multiple jurisdictions take the companies that we work with for our pitch tech services for example most of these companies are looking to solve Global problems with a tech product and

6:55 they're aiming at raising hundreds of thousands of dollars in this round and then raise another round maybe a few million dollars a couple years down the line that means that they're going to have investors today and then a new batch of investors a couple years down the line and each one of them is going to have a different valuation and maybe a potentially different set of rules on how their investment or their stock behaves for example you could have the second round of investors want a clause to protect their investment in case the company goes bankrupt and what would happen is that if the company has to liquidate their assets they they could make a rule so that they get paid first before anybody else cuz they were the last investors to come in this is relatively easy to solve in a C Corp with a model called preferred stock but even to understand any of this you need to understand that concept of ownership percent and how this pie chart is not

7:41 the way things work in the real world or in SE corpse cuz we always think of percentage of ownership and we have Hollywood to blame for that 51% of the voting stock 51% of the voting stock 51% share of your company 51% attack but this is probably the most important difference between n LLC and a CP and LLC is designed or envisioned as a partnership where different partners agree to own different percentages of this company when an LLC is formed the document that defines how this is split is called the operating agreement it's essentially like a rule book of how your company will run or or who's going to make the decisions or who's going to get the profits so the operating agreement might say that the owners of the company have equal rights to profits and to ownership and that would look like this

8:29 in a but corporations on the other side aren't made of Pies they're they're made of shares of stock and you've heard about these 40,000 shares 50,000 shares 2,000 shares a half a million shares in the bag 1 million shares so SE Corps are almost built to be split and resplit instead of thinking as a C Corp as a pie chart you need to think of it as blocks a C Corp for those three founders could be structured as a company with 1,000 blocks 400 400 and 200 say for each family now here's the question what happens if this C corporation if they want to bring new investors into the business bring investors on a C Corp is actually very easy all the company needs to do is create new shares so a whole new batch of shares is going to get

9:14 created each time there's a round of investment this means that shares are not going to exchange hands they're a constant as a Founder you're always going to own the same amount of shares but as new shares get created each shareholder's percentage ownership changes they're going to own the same number of shares but the company now has created more shares this structure even allows for new shares to operate with with a different set of rules like the right to vote or these uh liquidation preferences we were talking about each batch of shares can have sets of rules and new shares don't change that why is a C Corp much better for multiple rounds of funding we just need to take into consideration that SEC Corp were the legal vehicle for

9:59 designed for most the most complex business operations so after certain level of complexity and I will use Just sh an example share splits issuance of shares multiple different M mechanisms that are very very usual in let's say Tech business just to take an example were originally this designed for for C Corps so otherwise after a certain time of operation llc's might be short in some of these needs that the company may have and also trying to force the application of circuit mechanisms to the LLC May raise eyebrows when it comes to

10:45 subsequent investors or anyone conducting due diligence in the in the business a lot of startups also offer stock options as a benefit for their employees and then we have a whole video about that if you want to watch it so this is essentially what C Corps are made for and llc's are they're really inefficient at this because to to to bring an investor into an LLC they need to be added as a new partner as a new owner so the operating agreement needs to be changed every time needs to be Rewritten a new one needs to be instituted in the company so what effectively happens with every new investor is the company gets restructured a new rule book gets written every single time and this is simple for one round of funding and that's fine on an LC but it can get really messy if the company intends to raise multiple rounds it can't be

11:32 done a lawyer will tell you it can't be done but it's just very cumbersome because you're essentially trying to pack all these rules into an operating agreement now you probably figured out by now that without stock an LLC also can't become a publicly traded company because it just doesn't have shares that it can easily sell to other people but here's the point once again it's only a very specific type of company that needs these characteristics it can be done Alternatives exist you can even convert an LLC into a C Corp but if your intention is the fast growth path the startup to the moon path you're better off starting with a C Corp from the get-go now we have to talk about taxes again so remember we mentioned that double tax problem the secorp pays federal taxes on their profits and then

12:18 if shareholders collect dividends from the company they have to pay taxes again that sucks but it is just the reality if you need a complex corporate structure with multiple Shar holders and LLC on the other hand is actually incredibly flexible about this I mentioned the owners can just collect the profits directly they they can pay uh self-employment tax on those earnings on an individual level but here's a really cool trick anybody thinks that taxes are cool but the LLC can actually choose to be taxed as a corporation which actually would allow it to deduct some different tax write ofs or benefits like employee benefits I'm I'm I'm not going to dig any deeper into that because the question of how to be taxed really depends on a lot of tax math that is super custom to each business just remember with an LLC you can choose how

13:06 to be taxed okay so now let's talk briefly and before we end up on on State and international lines because people entrepreneurs investors overwhelmingly prefer Delaware companies the state has these business-friendly laws they have experienced corporate courts in case you have to go to court and no state income tax if you operate outside of Delaware most recently Wyoming has also become a popular state performing your company and you can see Wyoming as an option in a lot of uh in a lot of platforms that let you incorporate why is Wyoming suddenly popular yeah if that's a you know a platform related choice I will I will say that it's it's simply because of the ease of incorporating of forming a company or a corporation in these jurisdictions but there's no a specific tax purpose again in modern state tax

13:52 law interpretation yes the incorporation place of a company it's important but also you know the effective Nexus that it has economically to that specific state so you know a lot of a lot of different aspects need to be considered for establishing a company state tax obligations in the spite of the place of which that company is actually Incorporated now internationally sort of the same idea exists llc's as transparent entities versus corporations does that generally apply in other countries uh you know were there some common exceptions that that people should know on on L versus C Corps outside the US I will say that U there are however in civil law countries is not um is not frequent to find uh legal

14:39 structures that on the legal side will provide you with a legal protection and incorporate bail and that on the tax side will allow you to have this transparency just means that they are usually not as frequent or used as frequently as business Vehicles as in the United States for any for any International investor H you will always have to look both things know the the the place in which he is actually investing let's assume in the US and in these vehicles that we're discussing and then you will need to consider it's a home country implications for any operation that he may have abro so you have always take into account both perspectives right so to wrap up in a nutshell both llc's and C Corps have the liability protection they allow Founders and partners to agree on the business structure and

15:27 unprofitable for taxes because you can choose how to be taxed and then of course you can use taor Brands to get one setup in no time C corbs are better if you plan to have multiple shareholders rounds of funding or stock options for employees they're also better if your expectation is that your company will scale really really fast and potentially go public or be acquired if that's the case you should check out how we slidebean can help you do that see you next week