02: Starting the Business
Choosing a Business Entity
When I first started TeaSquares, I was really confused about what business entity I should start. I heard that LLCs gave the most flexibility, but investors preferred C-Corps. I realized that choosing a business structure comes down to choosing:
- Ownership Structure
- Taxation Structure
Your business structure affects everything from day-to-day operations to taxes, liability, and how much of your personal assets are at risk. This chapter will guide you through the main types of business entities and help you decide which one is the best fit for your CPG brand.
Types of Business Entities
Sole Proprietorship: This is the simplest and most common form of business entity. It’s easy to set up, and you have complete control over your business. However, there’s no legal distinction between you and the business, meaning you are personally liable for all debts and obligations.
- Pros: Simple and inexpensive to establish, full control of business decisions, straightforward tax filing.
- Cons: Unlimited personal liability, harder to raise capital, perceived as less professional by investors and partners.
Partnership: A partnership involves two or more people who share ownership of a business. There are two main types: General Partnerships (GP) and Limited Partnerships (LP). In a GP, all partners share liability and management duties. In an LP, there are both general and limited partners, with limited partners having limited liability and no management responsibilities.
- Pros: Easy to establish, shared financial commitment, complementary skills among partners.
- Cons: Unlimited liability for general partners, potential for conflicts between partners, profits must be shared.
Limited Liability Company (LLC): An LLC is a hybrid structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. It protects your personal assets from business debts and claims.
- Pros: Limited personal liability, flexible management structure, tax options (can choose to be taxed as a sole proprietorship, partnership, or corporation).
- Cons: More complex to establish than sole proprietorships or partnerships, varying state laws and fees, potential self-employment taxes.
Corporation: A corporation is a more complex structure. It’s a separate legal entity owned by shareholders. Corporations offer the strongest protection to its owners from personal liability but cost the most to form and operate. They have extensive record-keeping, operational processes, and reporting requirements.
- Pros: Limited liability for shareholders, ability to raise capital through stock sales, perpetual existence.
- Cons: Expensive and complex to establish, double taxation (on profits and shareholder dividends), extensive regulatory requirements.
S Corporation: An S Corporation is a special type of corporation created through an IRS tax election. It allows profits, and some losses, to be passed directly to owners’ personal income without ever being subject to corporate tax rates.
- Pros: Avoids double taxation, limited liability, ability to raise capital through stock issuance.
- Cons: Stricter operational processes, limits on number and type of shareholders, increased IRS scrutiny.
B Corporation: A B Corporation (Benefit Corporation) is a for-profit corporate entity that includes positive impact on society, workers, the community, and the environment in addition to profit as its legally defined goals.
- Pros: Legal protection to pursue mission, brand differentiation, attraction of like-minded investors.
- Cons: Increased scrutiny and reporting requirements, potential for higher operational costs.
Considerations for Choosing a Business Entity
Liability Protection: Consider how much personal liability protection you need. If you have significant personal assets to protect, you might opt for an LLC or a corporation.
Tax Implications: Different entities are taxed differently. Sole proprietorships and partnerships offer pass-through taxation, while corporations face double taxation. S Corporations and LLCs offer more flexibility.
Investment Needs: If you plan to seek investment, corporations, especially C Corporations, are often more attractive to investors due to their ability to issue stock.
Operational Complexity: Corporations have more regulatory requirements and formalities compared to sole proprietorships or partnerships. Consider how much time and resources you can devote to maintaining these.
Future Goals: Think about your long-term goals. If you plan to scale significantly, a corporation might be a better fit. If you’re looking for simplicity and immediate tax advantages, an LLC could be ideal.
State Regulations: Different states have varying regulations and fees for business entities. Research your state’s specific requirements to ensure compliance and understand the costs involved.
Where to Incorporate: I recommend incorporating the business in your home state, why? There’s a lot of talk about registering in states like Delaware or Nevada because they are more business friendly. The catch is that if you register in another state, you also have to register in your home state and pay the expense of setting up and maintaining two registrations, which gets expensive.
Why Investors Prefer C-Corps
C-Corps can issue multiple classes of stock, providing greater flexibility in raising capital and structuring investments. This is particularly appealing to venture capitalists and institutional investors who seek preferential terms such as preferred shares. Additionally, C-Corps offer limited liability protection, ensuring that investors are not personally liable for the company’s debts and obligations. C-Corps are also more favorable for scaling and going public, as they are the preferred structure for initial public offerings (IPOs).
From a tax perspective, C-Corps offer significant advantages. Unlike S-Corps and partnerships, which must issue K-1 forms every year to shareholders for tax purposes, C-Corps only issue tax documents when distributions are made. This simplifies tax reporting for investors and can be a decisive factor in their preference.
TeaSquares was registered as a C-Corp incorporated in Delaware but based in Illinois. The goal was to raise VC money all along, so we chose that entity type. In reality, it made our filing situation more complicated as we had to also register as a “foreign corporation” in Illinois, and have to pay taxes to both states.
Choosing the right business entity is a foundational decision that impacts many aspects of your CPG business. Take the time to evaluate your needs and long-term goals, and consult with legal and financial advisors to make an informed choice. Whether you start small as a sole proprietorship or aim for rapid growth with a corporation, the right structure will support your business journey and help mitigate risks along the way.