Entity Formation Series :: Part 2 - What Type of Entity Should You Form?

After you have made the decision that it is time for you to form an entity, the next two decisions that need to be made are: (1) what type of entity should be formed; and, (2) in what state should the entity be formed? While these are two distinct questions, neither one of them can truly be answered without considering the other. This is because of the fact that entities are creations of state law, and state laws governing entities are not all the same.

While these questions can only truly be answered in conjunction, I am going to break them down into independent questions for our purposes. Of the two, it is usually easier, in my opinion, to first make the decision as to what type of entity to form. While the state where the entity will be formed should certainly be a factor in this decision, I am going save my analysis concerning that aspect of the decision-making process for my Post: Entity Formation Series Part IV - Where to form your Entity: Texas vs. Delaware. So, now let’s get down to brass tacks: What type of entity should you form?

When evaluating what type of entity you should form, the business model of the company in question is generally going to be the first factor that should considered.  Usually, business models, when viewed extremely broadly, are going to fall into one of two distinct categories:

(1)       Market-Disrupting Business Model. Under this model, the founders are usually (but not always) creating a tech startup that they believe has the potential to disrupt a market, eventually becoming a massive company, that receives venture-capital funding, goes public, etc. (i.e. the founders think they have a Facebook, Uber, Snapchat, Airbnb, etc. type of idea); or,

(2)       Any Other Business Model. This is the category that covers every other type of business model.

99% of companies will fall into Category Two, with the remaining 1% fitting into Category One.

If your business model falls into Category Two, you should likely form an LLC for the reasons listed in my Post: Entity Formation Series Part III(a) - Why a Limited Liability Company is (usually) the Best Entity Vehicle for Most Business Models, which explains why the LLC is the best entity choice for business models that are not seeking to disrupt a market.

If your business model falls into Category One, you should likely form a corporation because of the reasons listed in my Post: Entity Formation Series Part III(b) - Why a C Corporation is (usually) the Best Entity Vehicle for those Businesses with a Market-Disrupting Business Model.

While this rule is a vast over-simplification and there are certainly situations where it should be deviated from, it can be a helpful gatekeeping tool that allows founders to break very complicated decisions into much simpler, binary decisions. While this may be beneficial for purposes of clarity, it is probably not the best way to actually make difficult decisions, so I would please advise you to contact a local attorney to help you make these choices.

If you are unsure as to whether you are going to operate under the Category One or Category Two business model, then you likely need to do some further soul-searching, market research, or whatever it is you need to do to determine what the goals are for your business moving forward. If you are truly stuck on the fence, then my advice would be to lean towards the LLC.

There are several reasons why this is my recommendation. First, only a miniscule percentage of businesses that start out wanting to be market disruptors ever receive any venture-capital funding (the percentage of companies that begin with a goal of receiving VC funding that actually end up achieving this goal it is tough to precisely calculate. Numbers vary based on the article or study that you read, but it is possible that less than 0.05% of companies [or only one out of every 2,000] that is started will receive any VC funding). Do not let this discourage you if you do think you truly have a market-disrupting business model and the skills necessary to achieve great levels of success. While the low end of the spectrum provides that perhaps less than 0.05% of companies will achieve VC funding, other articles calculate that the odds are closer to three to five percent for VC-seeking companies.

If you truly have a great idea and can execute it, then you can certainly achieve VC-levels of funding; it happens all the time. Otherwise, there would be no Facebook, Uber, etc., and numerous other, smaller companies that have achieved great financial success. You simply need to make an honest evaluation of your business’s potential to achieve its goals when pursuing a market-disrupting business model, and an assessment cannot be honestly completed without knowing that the odds of receiving VC funding are against every business that is starting out. A failure to receive VC funding does not necessarily mean that a business, even those initially operating under a market-disruption business model, cannot be successful. There are countless businesses that make their owners tremendously wealthy and happy even if they never become one of Silicon Valley’s hottest companies.

Second, you can always convert your LLC to a corporation in the event that it is in position to receive VC funding. While it is true that this process will require additional legal and other related costs, having to convert your LLC to a corporation because you are in position to receive millions in outside investment is a good problem to have. Because of these two reasons and because, generally, the benefits of operating an LLC outweigh those of operating a corporation, I would recommend that an LLC be the entity of choice for most businesses with the exception being those companies whose business models and goals clearly fall into Category One above.

Now that I have provided a general rule that you can use as a starting point for deciding the type of entity your business should be, we need to address the other, related decision that was referenced at the beginning of this post: “Where should I form my entity?”

For some information on this decision, see my Post: Entity Formation Series Part IV - Where to Form your Entity: Texas vs. Delaware.