How to Choose the Right Business Structure

The decision of a business structure is critical when the business is likely to grow or expand very fast. The kind of structure you adopt impacts on all aspects such as your taxes, to personal liability, to raising funds. We will take this step-by-step and examine the important aspects of this, the various types of business structures and what to think about scaling your business within a short time.

Understanding Business Structures

To select the appropriate type of structure, it is the first step to grasp the most prevalent types of business and their characteristics. The best structure depends on your growth projections, industry and individual preferences and advantages and disadvantages in each structure.

A. Sole Proprietorship

• Definition: The least complex type of business structure is when the business and the owner are identical.

• Advantages:

1. Easy and inexpensive to form.
2. Complete authority over business-related decisions.
3. Pass-through taxes (profits are reported on the personal income tax return of the owner).

• Disadvantages:

1. Limitless personal liability of business debts.
2. Hard to raise capital, which could be a problem in the event you want to scale fast.
3. Lack of scalability since it is dependent on the capacity and resources of the owner.

This model is not normally advisable when the business anticipates fast growth of the business since there would be the liability of the individual and raising funds would be very hard.

B. Partnership

• Definition: A business structure that involves sharing of ownership and responsibilities of two or more people in running the business.

• Advantages:

1. Easy to form and flexible in operation.
2. Enough resources and skills to scale, unlike a sole proprietorship.
3. Pass-through taxation.

• Disadvantages:

1. It has a joint liability and this can be risky when the business is expanding and faces problems with the law.
2. The conflicts between the partners may interfere with business.
3. More difficult to control as it grows to a larger scale, particularly involving a number of partners.

Similarly to sole proprietorships, partnerships are not always the ideal scaling option due to the partners having joint liability and due to the complexity of the partnership agreements.

C. Limited Liability Company (LLC)

• Definition: A hybrid business structure that combines the flexibility of a partnership with the limited liability of a corporation.

• Advantages:

1. Business debts have limited personal liability of the owners (members).
2. Pass-through taxation, no double taxation (without a choice of corporation tax treatment).
3. Liberal management and ownership.
4. It is easy to raise funds as opposed to sole proprietorship or partnership which could come in handy as you grow.

• Disadvantages:

1. More costly to establish and run than sole proprietorships or partnerships.
2. Involves greater paper work and compliance as compared to simpler structures.
3. May has difficulties with raising capital in case you need substantial venture capital or fast growth.

LLCs suit most of the expanding businesses, offering limited liability and flexibility, yet they may still have issues with raising funds to expand fast.

D. Corporation (C-Corp)

• Definition: A legal person independent of its shareholders, in which the corporation is capable of owning property, incurring liabilities and paying taxes.

• Advantages:

1. Limited liability guarantees the personal property of shareholders.
2. Capital raising capability through the issuance of shares of stock, which is a requirement of scaling.
3. Permanent existence, i.e. the company will remain even in case of an owner departure.
4. Is able to provide stock options in order to attract talent.
5. Deductible Employee benefits.

• Disadvantages:

1. Dual taxation (corporation tax on profits, and shareholders tax on dividends).
2. More costly and difficult to install and use compared to other buildings.
3. Increased regulatory conformity (SEC regulations, annual meetings, etc.).
4. Rigid management organization.

C-corp is the type of company that is mostly suitable to the companies with high growth opportunities, in case you want to attract external funds (such as venture capital) or IPO. It offers great benefits in terms of capital as well as long-term scalability, however, the cost and complexity will have to be considered.

E. S-Corporation

• Definition: Similar to a C-Corp but with some tax differences, where profits and losses can pass through to individual shareholders’ personal tax returns.

• Advantages:

1. Shareholders have limited liability.
2. Pass-through taxation, in which there is avoidance of double taxation.
3. Less capital is difficult to raise compared with an LLC or partnership.

• Disadvantages:

1. Limitations on the stockholders (not more than 100).
2. Should be a domestic company, the stock of which is held only by U.S. citizens or residents.
3. Additional administrative and regulatory demands than LLCs or sole proprietorships.

Although an S-Corp can provide the tax benefits of a pass-through tax, it might not be suitable in the cases of extremely rapid scaling because of the limitations on shareholders.

Factors to Consider When Scaling

In a case of deciding on the business structure that best fits the rapid growth, the following are the key considerations that should be taken into account:

• Liability Protection

1. When your business is growing fast, then you are likely to experience more risks that might include lawsuits, regulated examinations, or financial difficulties. Limited liability coverage Clients are guaranteed that their personal belongings will be shielded against business liabilities and lawsuits.

2. Most appropriate protection structures: C-Corp, S-Corp and LLC.

• Access to Capital

1. You will require a lot of capital to be raised to scale rapidly. Investors would rather have a structure that they are familiar with and one that they can easily invest.

2. Most favorable to raise capital: The C-Corp is the most appealing to venture capitalists and investors because it can easily access equity capital (in the form of shares).

3. The LLLCs also have access to raising money but may have fewer chances to attract institutional investment since they usually prefer the stock options of C-Corps.

• Taxation

1. Businesses that are increasing at a very fast rate should be considerate of tax efficiency. Although LLCs and S-Corporations have pass-through taxation (they do not pay corporate income tax), the C-Corporations are subjected to taxation at corporate and dividend levels (taxation is charged twice).

2. This can however be at times offset by C-Corps through retention of earnings (not distributing profits) or by reinvesting the profits into the business.

3. Best for tax efficiency: C-Corp can be best in case you anticipate quick reinvesting of the profits. LLP or S-Corp will be more simple to pass through taxation.

• Management Flexibility

1. The organizational structure will be complex with the growth of your business. Your company should be able to increase its management structure as the company grows.

2. Best for flexibility: LLCs are loose with regard to the organization of management and decision-making. C-Corps are more rigid in their structure (board of directors, etc.) and tend to be in a better place to manage larger-scale operations.

• Exit Strategy

1. A C-Corp is generally the most suitable type of business in case you intend to sell it or make it public. The more common feature that is sought after by investors is the possibility to sell shares or go public, which is easier in a C-Corp.

2. Most suitable in case exits are concerned, C-Corp is the choice in case you want to make a public offering or have high-level investors.

Choosing the Right Structure Based on Growth Strategy

• If you’re bootstrapping and need flexibility: LLC could be a good choice due to its protection of liability and easy nature. This frame provides you space to scale, but in case you intend to raise capital in the future, you might be required to switch to a C-Corp.

• If you plan to seek venture capital and want a scalable structure: A C-Corp is probably the most suitable. It provides the issuance of stock, which investors are fond of, and greater scalability on large investments.

• If you plan to go public or attract institutional investors: C-corp by far is the most preferable structure as this is how IPO is done and big time investments are made.

Conclusion

The C-Corp structure is usually the most flexible, provides the best liability coverage, and has access to capital when you are planning to grow fast. Although it is accompanied by the disadvantage of double taxation, no other can be compared to it in terms of attracting investment, offering stock options, and expanding across the world.

In case you need to be flexible and do not face double taxation at this time and are not interested in venture capital, LLC or S-Corp may be a better place to start. But when you grow larger, or receive larger amounts of funding, you might have to change to the C-Corp.

All in all, what you choose will be based on your individual requirements to protect yourself against liabilities, tax benefits, flexibility in management, and access to funds.

Disclaimer

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