Putting Thought into Your Business Entity Type
Your business entity type and location can have significant bearings on your ability to raise money. Read about what happened to Ted, a software entrepreneur, when he made a few mistakes along the way.
We’ve all heard the beginning of this story before. Ted was a capable software engineer with a bright idea and a speedy internet connection. From the comfort of his own home, he was able to start a burgeoning enterprise. While Ted was a confident software engineer, going into business for himself was a new process and Ted looked to his friends for advice as he grew his new company.
Early on, a friend had suggested he form a Limited Liability Company for liability protection. Sound advice, easy enough to follow through on, and a good risk-reward tradeoff. So he formed his software company as an LLC and pushed onward.
Pretty soon he needed some help with coding and turned to his colleagues, Mike and Sandy, as he developed new features for his digital products. It was a simple business relationship. As business entities, Mike and Sandy were each a Sole Proprietors who did contract work for Ted from time to time. Again, a common storyline as anyone starts a new business.
Over time, the trio realized that they all worked well together. After some initial successes, late night coding sessions, and maybe a few drinks to toast to progress, they decided to “take the software to the next level” by pulling their resources together in one company. They could do even more working together on a regular basis.
Since Ted owned the main software product and already had an LLC, he guessed he should bring Mike and Sandy into his company. Ted did his own research on this and learned that in his home state it was possible to add members to the existing LLC. So, that's what they did as they proceeded forward.
As more time went on, the team starting looking to raise money for business expansion. They kept hearing that if they raised investment capital, investors would typically want to buy shares in a C-corporation. (For fundraising purposes, LLCs generally aren’t great for raising money.) There was some interest in their company coming from potential investors, so they decided that incorporating needed to happen.
Ted went back to a friend, this time a lawyer, for advice regarding forming a C-corp. The lawyer had done this in his state but had also set people up in Wyoming and Delaware. Incorporation is common in Wyoming, Delaware, and Nevada where they have laws and tax structures that are very friendly to corporations. You’ll see here that Wyoming might seem like an obvious choice for incorporation—it checks all the boxes and in many cases is a great choice.
Ted, Mike, and Sandy decided to “go with what’s cheapest” as they incorporated, which at the time was Wyoming. Again, not necessarily a bad decision. The investors they met were impressed with their product and its direction and eventually, they found a major investor who had done other software deals. They told the investor they had a C-corp and she was ready to draw up the paperwork.
However, as they dove into the details, the investor came back and said, “I thought you had a Delaware C-corp. That’s common for software investment these days, and what I prefer to work with because the court system is set up to handle corporate issues well if we run into trouble down the road.” Ted, Mike, and Sandy looked at each other in disbelief.
Luckily, this bump in the road didn’t shake the investor’s belief in Ted’s product. But it was clear that she wasn’t going to move forward with a substantial investment in a Wyoming C-corp. Ted was forced to re-incorporate as a Delaware C-corp. The whole process ended up taking three months. While that time certainly didn’t sink Ted’s company, he spent an entire quarter waiting to re-incorporate when his business could have been growing.
For another business, forming a C-corp in Wyoming could have been the best option. For others, sometimes Delaware will make the most sense, sometimes Nevada, and sometimes one's own home state. Like so many new business owners, Ted’s expertise was in something besides starting a business. While he was grateful for his friends’ advice, he wished he had done some more research on his own or sought out a second opinion.
Ted’s story illustrates the importance of research and planning as you grow your business. If you’re thinking about what business entity would be best for your business, check out the Entity Planning section in StartBlox.