IgniteU NY is a program that focuses on both fostering and maturating New York State entrepreneurs; connecting them with the robust startup community in the Capital Region and helping them establish, develop, and refine a comprehensive entrepreneurial skill-set.
The community building program, a NYSTEC initiative, offers guidance and incubation / acceleration services to Capital Region entrepreneurs and startups at various stages of development. IgniteU’s flagship program, a traditional accelerator program that runs for eight weeks each summer, allows for a select group of core startups to “develop and validate their business model, build a strong business foundation, and enhance the founder’s networks.”
This season, the core teams in the IgniteU accelerator are: Inky, a personalized book subscription service, U-Topia, a mobile app for university dining, and Illuminate ESI, a digital forensic service company.
“We learned so much more by being in this program,” said Mikayla Lansing, Inky team member. While the team has taken previous entrepreneurship classes, they still found that since, “People explain [things] differently, we get new perspectives.”
Lansing continues, “We were really drawn to IgniteU because of their mentorship program and they don’t take equity like other accelerators. Most of the mentors are actually interested in and excited about actually helping you.”
Eric Leander, one of the founding partners at The Wagoner Firm PLLC, is a mentor for IgniteU. Leander provides weekly office hours to IgniteU participants and recently gave a brief lesson that introduced the young entrepreneurs to typical legal issues they can expect to face as they pursue their ventures. One such critical legal matter is determining the most suitable business entity, capital structure, and internal governance policies for such enterprises.
While seemingly a very simple topic, there are many factors of which first-time entrepreneurs may not be aware, which play a role in both choosing and structuring a business entity up-front (and positioning smooth transition of the business over time as it grows and brings on investors, new directors, officers, employees etc.).
There are many basic entity types to choose from and each one possesses different benefits, risk mitigation, liability protection, tax treatment, and forward-looking flexibility. Eric’s recent lecture covered the following entity types and aspects of their taxation and operational flexibilities:
- Sole Proprietorships (a/k/a DBAs)
- Partnerships (General & Limited Partnerships, Joint Ventures, Limited Liability Partnerships etc.)
- Corporations (distinguishing between tax elections e.g. C-Corps and S-Corps)
- Limited Liability Companies
“Slowing down at the beginning and thinking things through with the short-term, intermediate-term, and long-term development arc of a startup is important in my opinion,” Leander said. “It’s easy for many entrepreneurs to try to DIY the formation process, especially first timers, but if they haven’t considered all of the angles and/or they haven’t been down this road as many times as I have, it’s not hard to make a mistake that can be inconvenient or costly to fix later. Worse would be a fundamental error that makes the company non-investable,” he added.
Here’s a quick rundown of the basics of each of these types of entity:
Sole proprietorships are a fast and low-cost method to begin a business, but they aren’t actually a separate business entity that shields the owner / operator from any liability. “Quite the opposite,” Leander noted, “sole proprietors have unlimited personal liability for liabilities arising from their business.” Business liabilities become personal obligations that can affect the sole proprietor’s own personal finances and subject their personal / non-business assets to significant risk. Leander noted “given the relative low costs of establishing a basic business entity versus the risks it protects individual business owners from, it generally doesn’t make much sense to be a sole prop / DBA.”
Partnerships are business relationships that are essentially a contractual arrangement / agreement having similar qualities as sole proprietorships but involving multiple parties. In a general partnership ach partner has unlimited joint and several liability, meaning that they are responsible not only for their own personal conduct, but for their partner’s conduct as well. Here again, the personal assets and finances of the partners are subject to the risks and liabilities arising from business activities.
Leander noted, however, “You’ll quite often see partnerships deployed in certain contexts among other business entities – we call these joint ventures. Nevertheless, more and more, we are seeing these joint venture partnerships between business entities being structured using other limited liability entities for a variety of reasons.”
Limited partnerships involve a general partner and a passive (i.e. limited) partner, the passive partner is limited in their liability to the amount that they have contributed to the company and is not personally liable, as a general matter, for obligations of the business itself.
Limited Liability Partnerships are typically used by the “learned professions” (e.g. architects / engineers, accountants, attorneys and doctors) where there is professional malpractice liability. Unlike a general partnership, an LLP protects each partner legal protection from malpractice liability associated with the conduct of the other partners. “Here again,” noted Leander, “with the rise of newer business entities such as professional corporations / associations (P.C.s & P.A.s), together with professional limited liability companies (PLLCs), the LLP structure is likely becoming, if not already, obsolete.”
Corporations are legal entities that exist separate and apart from its owners (i.e. shareholders / stockholders). “For most intents and purposes, a corporation is treated like a separate ‘person’ insofar as it stands apart from those that own it and that it can, on its own behalf, do most of what an individual business person could do (e.g. pay taxes, open bank accounts, enter contracts, sue and be sued etc.). Corporations are able to raise capital by selling stock or issuing debt.
Corporations also are separate tax paying entities and follows its own designated tax rate depending on its chosen tax treatment. Here, Leander noted the distinction between tax elections made under Subchapters C and S of the U.S. Internal Revenue Code (what most would understand and C-Corps / S-Corps.)
“It’s important to understand that a ‘C-Corp’ or an ‘S-Corp’ isn’t actually an entity type,” said Leander. “Rather, they are simply a tax election made by the entity – whether to be taxed under particular sections of the U.S. tax regulations – specifically Subchapter C or Subchapter S of the Internal Revenue Code.”
- C-Corporations are separately taxed entities obligated to pay income taxes on its own revenues (after deductions) much like an individual. However, C-Corps raise the issue of “double taxation” insofar as any dividends / distributions paid to shareholders are then taxed at the shareholder level – usually at a lower capital gains rate. Eric commented, “At first glance, this tends to sound unfavorable, however with proper tax planning and for a variety of other reasons, the impact of double taxation can largely be mitigated.”
- S-Corporations are still separate business entities. However, for tax purposes, they are what is known as a “pass-through entity,” disregarded as a taxpayer separate and apart from its owners. Pass-through entities, like S-Corporations, are able to pass profits and losses through to their owners – which can be advantageous if the owners have other income that can be offset by business losses.
“However,” Leander noted, “S-elections can be problematic for high-growth startups that plan to take on outside investors to fuel development and growth.” This is because companies electing taxation under Subchapter S have limitations that are generally not suitable for subsequent investment (e.g. stockholders can only be natural persons as opposed to funds, foreign investment is strictly limited, and the company can only have a single class of stock as opposed to both common and preferred).
- Limited Liability Companies (LLCs) are a hybrid of corporations and partnerships. It is a legal entity that is separate from its owners while limiting their liability to their capital contribution. However, from an operational and internal governance perspective they have much more flexibility. Moreover, from a tax perspective,hey can choose to be taxed as a sole proprietorship, partnership, C-Corp, or S-Corp.
As a company grows, they may need to change their entity formation to better suit their needs. What may have started out as a sole proprietorship, such as a local restaurant, may eventually change into a C-Corp if they decide to expand and franchise. Similarly, a successful service business formed as an LLC may be required to convert to a corporation if an acquirer comes along having particular tax needs. Being thoughtful and strategic with respect to entity selection, formation, governance and documentation is a critical first step in setting a company up for future success.
“Here at the Wagoner Firm our goal is to build lasting relationships with startups and entrepreneurs. We want to see them through the life cycle of their company and watch them grow. Our legal services are catered to their needs at every stage of their company” added Leander.
Beyond the core teams, IgniteU also has programs for early stage and more mature companies in their accelerator program. The early stage companies are those that may still be side hustles for their founders. These companies are known as affiliate companies in the accelerator. The program aims to give these early stage company the basics of starting a company.
On the other side of the early stage company timeline, more developed companies that have already received funding, generate recurring revenue or have serial entrepreneurs on the founding team can also be a part of the accelerator program as Startups-in-Residence. These companies are able to take advantage of the offerings of the core accelerator program while also providing mentorship and advice to those companies.
“There are a number of different factors that feed into entity selection. I typically like to find out what a company’s short, medium, and long-term goals are first. Then I always look to understand what their realistic expectations and time-frames for external investment financing are. Another major consideration I take into account is the intent to compensate and/or incentivize employees, contractors, advisors, and others with equity compensation. I also take into account whether the founders have outside income against which business losses could be written off.” Concluding his statements, leander noted, “There’s not really a ‘one-size fits all’ business entity. A good attorney and a smart entrepreneur will take more than the immediate circumstances into account; not only when selecting an appropriate entity to create, but also when crafting internal governance documents, contractor / employee arrangements, and capital structure planning and maintenance for companies that expect / intend to raise money from third-party investors.”
The core accelerator teams will present their final pitches on August 2, 2017 at the Final Startup Showcase. Register for their demo day here.
Source: Eric Leander – Startup and Small Business Presentation
DISCLAIMER: This post is intended for informational / educational use only. There is no attorney / client relationship established. Consult a qualified attorney prior to taking any actions based off of this post.