Hustler Series: Forming A Business

15: Forming A Business

A major part of launching a new product is forming a new business. Forming a business is a necessary step and something that you’ll want to think about early on when evaluating your product idea. This post will help you learn the basics of choosing a business structure, choosing a business name, and the typical processing times for paperwork.

First let’s go over the business structures. In general you can form your new business as a sole proprietorship/partnership, an LLC, or a corporation. The scope of your product idea and the kind of liability you’re willing to take on are the two major driving forces of your ideal business structure. So let’s see what advantages each structure has.

The most basic business structure is a sole proprietorship. This isn’t really a formal business structure and, instead, features you as the sole owner of the company where the IRS sees your business as an extension of you. The advantage of this is that you don’t have to file paperwork to set it up. All you have to do is report your business profits as personal income when you file your personal taxes (which means paying self-employment taxes on those profits) and you’re good to go. The key disadvantage of this structure is that you’re personally liable for the company’s debts and, if your company gets sued, all your assets (your savings, your car, your house, etc.) are at risk of being lost. So you sacrifice convenience for liability. In my opinion the liability is not worth the convenience and you should avoid this structure unless you have a very good reason.

Similar to a sole proprietorship is a partnership. A partnership is basically the same as a sole proprietorship but with two or more people. Everyone in the partnership is still liable for the company’s debts and must file their individual profits as personal income on their tax return. So you have the same tradeoff of convenience for liability as a sole proprietorship but now there are more people in your company. Because of this liability I again recommend avoiding this structure unless you have a good reason. It’s fine to run as a partnership during the early stages of your business but, once you start ramping up for production and get ready to sell your product, I would advise a structure that puts you at less personal risk.

This is where LLCs and corporations come in. These are two formal business structures that allow you to treat your business as an entity, which means it is liable for losses instead of yourself. In general, LLCs are more suitable for small businesses while corporations are more suitable for larger business and startups searching for fundraising.

A Limited Liability Company, or LLC, is a state-level business structure where the company is the liable entity instead of the employees. It operates much the same way as a sole proprietorship or partnership but has the added benefit of liability protection. However this comes at a cost. You will have to file paperwork and pay filing fees as well as annual fees and taxes to the state to maintain your LLC status. These fees are state-specific and range from $0 in Arizona to $800 in California. So be sure to check what your own state will require if you decide to form an LLC. The main reason LLCs are used by small businesses is because they have flexible management structures. You don’t have to worry about setting up a board of directors or anything; you can just operate as you would a partnership but with the added liability protection. Unfortunately this increased flexibility comes with two major disadvantages for startups that require funding: LLCs cannot issue stock options and cannot go public. This means investors may be less likely to fund your startup since they can’t cash in on stock increases and an IPO. So if you genuinely think your product and company will get to this level or will need investor funding, I don’t recommend an LLC. But for most small businesses an LLC is the right choice.

Incorporating your business is the other structure option. A corporation is similar to an LLC in that it’s treated as a liable entity instead of its employees, but its structure is a bit more complex in nature. Instead of the flexible management structure of an LLC or partnership, a corporation must have a strict structure involving a board of directors, executives, employees, and shareholders or owners. In this structure the primary responsibility of the board of directors is to protect the shareholders’ investments and to appoint officers who will act in their interests. The officers (CEO, COO, vice president, etc.) are responsible for leading the everyday business operations and act in the best interest of the corporation. Then you have the employees who include everyone else working for the company that report to the officers. For small business this structure isn’t always necessary and the less formal structure of an LLC may be preferred. But having a board of directors and shareholders makes corporations much more attractive to investors. That’s because it allows them to invest early, which gains more shares of the company, as well as gain early representation on the board of directors, which helps shape the company’s vision. This means forming a corporation instead of an LLC is a huge advantage when it comes to finding investors. However there is a potential disadvantage when it comes to paying the corporate tax rate. A small business with a corporation structure will need to pay the corporate tax rate on their profits and then the employees will also pay personal tax on their earnings. So the earnings will be taxed twice instead of once like under an LLC. But the corporate tax rate is lower than the maximum personal tax rate so, if your business is making a lot of money, it can actually be advantageous to pay the corporate tax rate (especially since it was just lowered to 21%). So my suggestion is for small businesses to form an LLC unless they plan to take on investors or expect to turn a large profit.

In addition to selecting a business structure, you’ll need to select a business name. Choosing a good name is crucial to starting off on the right foot. While I won’t get into strategies for brainstorming strong brand names, I can help you confirm that your name is legally unique. The first thing you’ll want to do after you have a name in mind is check whether there’s a trademark for it already. If someone already has the trademark to the business name, you’re out of luck and will need to think of something new. Luckily it’s easy to check trademarks. Just go to http://tess2.uspto.gov/, choose “Basic Word Mark Search”, and search for your proposed business name. If the results come back with no matches, you should be clear to move onto the next step. This is making sure the business name is available in your state. Someone may already be operating a business under your proposed name but didn’t bother to file a trademark to protect the name. To confirm your name is available, you’ll want to do a search through your state’s database of businesses. A search function is typically available on your state’s government website. If you want to start a business in California, for example, you would do a name search at https://businesssearch.sos.ca.gov/. And if no results come back with your proposed name, you are fully in the clear to form a new business under that name. All you have left to do is file the necessary paperwork.

And luckily the Internet has made filing fairly easy. Ideally you should talk to a lawyer or someone familiar with the procedures of forming a business before you actually form your business. But, if you know what you’re doing, it’s not too difficult to file the paperwork yourself. The cheapest method is to find the required paperwork online, print and fill it out, and then mail it to the proper department at your state capital. Each state will have its own unique paperwork and filing fees but the general process is the same. With California, for example, you can find the required forms and helpful information about filing procedures on the Secretary of State’s website. Simply print out the Articles of Incorporation or Articles of Formation paperwork, fill in your information, and mail it to the “Document Filing Support” P.O. Box in Sacramento. If you’re uncomfortable doing it yourself, you can also hire a lawyer to help you or use an online service like LegalZoom. I personally used Nolo’s online service to form my LLC because I wanted some reassurance that I didn’t miss any paperwork. Online services like these are very easy to use and can be a good compromise between spending a bit of money on an experienced lawyer and filing the paperwork completely on your own. But, again, all the information is available online so you shouldn’t need to use a service. And as for the typical processing time, you should expect to receive your confirmation paperwork 2-4 weeks after submitting it. Your state may also offer an expedition fee to cut this time in half. But it’s good to be aware of how long it takes to legally form your business because it’ll be a bottleneck when it comes to applying for business bank accounts, credit cards, etc.

And after you file for your business you’ll want to apply for a trademark of your company’s name. The process is very similar to the previous step. You can freely find all of the information and required forms on the USPTO website if you want to do it yourself or you can use an online service or hire a lawyer to help you. It’s recommended that you consult a lawyer if you’re new to the process because there’s a bit more legal nuance involved but it’s not strictly necessary. I personally used the online service Trademark Engine to help me navigate the process but I’m sure hiring a lawyer would have helped me draft a stronger trademark claim. So be aware of the benefits you gain from spending money on an experienced professional. You can also expect this to take 2-4 weeks to process.

So there you have a general overview of the various business structures, how to legally form your business, and how to protect your company name. It call all be a bit overwhelming if you’re completely new to the business world, but online services and experienced lawyers are here to help you get more comfortable with the process. And once your business is formally set up, you can start pursuing finance options.