I am in the process of writing this up as the next chapter of my online book but a family emergency came up so rather than waiting, I will just repost an earlier comment.

http://www.StartupForLess.com

Assuming your are a bootstrapper meaning that you have a few co-Founders who are the key contributors and can each afford to not take salaries for at least two years to get the product off the ground, then your best bet is to form a LLC (Limited Liability Company). Keep in mind that bootstrapping is not a permanent state of mind but rather a pramatic approach to build a viable company and maximize your chance of success as well as your networth. If the old argument was "A small slice of a larger pie is better than a large slice of a small pie", bootstrappers are all about getting a "medium slice of a medium pie". The idea here is that you want to take the company to a point that if you still need money from a VC, you take money when all you need is money.

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My experience is that LLC (Limited Liability Company) is a much better vehicle for starting a company than a S-Corp. LLC is an interesting hybrid between a corporation (S or C) and a partnership.

Legally LLC is not a corporation but more like a partnership. But it is an effective shield for limiting your personal liability the same way that a corporation would, yet at the same time, doesn't require the declaration of a liability-bearing general partner which is what you have to do with a Limited Liability Partnership (LLP).

Also, from the customer perspective, an LLC sounds a lot like a corporation so it doesn't have the stigma that comes with an LLP (people think of dentist, doctor and lawyer when you present them a business card that says LLP). Just like LLP or a S-Corp, an LLC is not a taxable entity so losses and profits can flow directly to the partners.

On the other hand, unlike an S-Corp, the profit and loss can be distributed anyway that is agreeable to the partners and not necessary according to the percentage ownership, which is very convenient.

Also, LLC has no limitation on foreign ownership or ownership by another corporation (Until it became AT&T again, Cingular was a LLC owned by SBC and BellSouth).

All it takes to form a LLC is an operating agreement, which is not even a legal document and does not need to be filed. So you don't need a lawyer to do what is basically common sense. So be sure you spell out the ownership structure of the LLC (there is no reason why it has to be equal but there is no reason why it cannot be, so whatever is agreeable to all partners is fine).

But be sure to spell out the circumstances when a particular partner is deemed non-contributing and therefore can be invited out by the rest of the partnership. Also, spell out what happens to his/her shares if any partner was to resign, to be terminated with and without clause, incapacitated and death (either work-related or not).

So a typical solution is to give everyone three or four years to vest and everyone agree that any shares that are unvested can be repurchased by the remaining partners at the original price. Also, make sure that everyone agrees to a right-of-first-refusal and a co-sale arrangement so that if one partner decides to sell his/her vested shares, everyone else has the right to either buy the shares or to sell part of their own vested shares to the same outside buyer at the same time.

Furthermore, make sure you put a price on the shares so that everyone writes a check and buy the shares outright (which can be very low so that the total is on the order of a few hundred dollars). This is very important because once the stock is purchased, you have started the clock for capital gain and keep in mind that these are 1244 stock which means that if you keep them for five years (which you probably will since that's how long it will take to build a company if not more), then only half of your capital gain is taxable.

There are other benefits as well but the most important one is that if you ever leave your own startup, you can walk away with property that you already owned and you don't have to worry about exercising your options and get hit with Alternate Minimum Tax (AMT).

On the other hand, for working capital, ask everyone to put in the cash as an interest-bearing loan so that when the company starts making profits, you can get the money back without any tax consequence.

Also, even as a LLC, you can elect to file your tax return as a S-Corp. This is important because as you continue to bootstrap your company, instead of paying the partners salaries, you can pay everyone a nominal stipend (which is subject to payroll tax) and declare the rest dividend, which is not subject to self-employment tax (it would be if you file tax return as a LLC).

Finally, when you are ready to take VC money, they will want to bring in a high-power lawyer and chances are that they will want you to form a C-Corp. By then, you can do a tax-free transfer between assets of the LLC and shares of the new company. The VC's are going to put a vesting schedule on your new shares, which you will need to negotiate. But hopefully by then you have some leverage (like customers and profitability) and you can negotiate from a position of strength.

But the most important issue here is that with a C-Corp you can start from a clean slate which is what the VC's want.

Hope this helps.

--Denny--

Denny K Miu