Five-minute general counsel: incorporate a tech startup

Another LinkedIn user asked about how to structure a startup that would be a typical VC-funded software company.

Here’s my edited answer:

As someone who’s represented dozens of startups, closed probably 100 venture deals, and cleaned up too many small companies to count, there is in fact a right way and wrong way to do this.

The best way, if you’re planning on a software company that will be seeking traditional VC money, is to form a Delaware corporation, taxed as a C-corp, that owns and develops the IP (the software). That structure works for VCs without creating problems.

Here are some quick points:

  1. Using an S-corp or LLC taxed as a partnership means that there can be leftover tax liabilities. It’s not worth the trouble to diligence them, so you’ll just end up either killing the deal or hopefully putting the existing entity behind a chinese wall and having it be a shareholder in a new — yep, Delaware c-corp.
  2. Profit sharing with employees can be done in many ways, but stock options are straightforward and well-understood both by VCs and software engineers. There’s a plethora of information available to everyone on how to value, structure, exercise, and pay tax(!) on them.
  3. Ownership, management, and governance can be turned into sticky problems. Using a standard structure like the DE C-corp helps everyone focus on the actual issues instead of the wrapper.

The only realistic alternative, if you have substantial other income that could be sheltered and sufficient skills and funding to bootstrap for a while, would be to use one of the alternate structures (LLC w/partnership taxation) deliberately so as to harvest tax losses while you are developing to the point that you will seek VC funding and then execute the chinese wall maneuver I described earlier.

Think of it this way: it’s hard enough to have a great idea, start executing it, interest a VC, and close funding. Why would you let something like an uninformed legal entity structure jeopardize your deal? As you can tell, I’ve taken companies down several of these paths. Some are way better than others.