Who says you can’t start a business when you’re young? These days, more and more young entrepreneurs who are full of great ideas, passion, and drive are launching their own companies—any many are finding success.
I recently had the pleasure of serving as a mentor to a number of young entrepreneurs as part of the innovative U.C. Berkeley-Hass Entrepreneurship Program, which is under the outstanding leadership of Rhonda Shrader and Adeeba Fazil. The program offers undergraduates, graduates, and alumni an opportunity for career counseling, professional networking, and more to help boost their entrepreneurial endeavors.
The young entrepreneurs I counseled had some great, creative ideas for different startups, and many of them had already gotten some early traction in their businesses. They also had some great questions—questions that many entrepreneurs, young or old, have about starting, growing and financing a business. So I thought I would share my answers to those questions here.
1. I’m Just Starting My Business. What Kind of Entity Should I Set Up?
The founders of a company must initially determine whether to organize the company as a limited liability company (LLC), general partnership, a sole proprietorship, or a corporation. If formed as a corporation, the company must also determine whether to file an election to have it taxed as an “S corporation” rather than a “C corporation.”
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their stockholders for tax purposes. Stockholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates (so called “flow-through taxation”). This allows S corporations to generally avoid double taxation on the corporate income.
A C corporation under federal income tax laws is one that is taxed separately from its owners. Generally, all for-profit corporations are classified as C corporations, unless the company validly elects to become an S corporation. A C corporation does not have limits as to who could be the stockholders (as S corporations do). And C corporations may have different classes of stock (such as preferred stock and common stock), which is not allowed for S corporations. Venture capitalists will typically only invest in preferred stock in a C corporation.
An LLC is another entity that provides limited liability to its owners the way C and S corporations do, and an LLC also provides flow-through taxation to its owners.
So what type of entity should a founder form?
- Never form the company as a general partnership or sole proprietorship, as these have the huge disadvantage of potential liability to the owners for the debts and liabilities of the business.
- If properly structured and run, LLCs and corporations can protect the owners from personal liability if something goes wrong with the business.
- If the company will be getting outside investors, it will most likely need to be a C corporation.
- If it’s a simple company with one or two individual owners, an S corporation makes sense. You can always convert it later to a C corporation.
- If the owners want greater flexibility for types of owners and wish to avoid the restrictions of S corporations, then an LLC or C corporation can make sense, although LLCs tend to be a bit more complicated to set up and maintain (and more complicated for tax filing purposes).
For a comprehensive discussion of tax issues in startups, see Pay Attention to These 9 Essential Startup Tax Issues.
2. Where Should I Incorporate My Startup?
Corporations are formed pursuant to a state’s laws. Many people recommend incorporating under Delaware law, but my preference is to incorporate in the state where the business is located, as this will save you some fees, filings, and complexities. You can always reincorporate later in Delaware if desirable.
3. I Have a Great Idea That Has No Competition. How Can I Protect It So Others Don’t Steal My Idea?
Ideas are a dime a dozen; it’s the actual implementation of an idea that is more important. If it’s truly unique, get a patent for it (visit www.uspto.gov). You may get some protection through copyright, trade secret programs, or NDAs—but not a lot (see The Key Elements of Non-Disclosure Agreements). You can’t worry too much about someone stealing your idea. The best thing to do is implement the idea and get a lot of traction for it.