Your Startup Purpose Determines its Legal Structure

Debra Innocenti-Placette of Innocenti Jones, PLLC is one of the top internet and cyber lawyers in Texas. Based in San Antonio, she maintains a diverse legal practice for emerging companies in technology and internet-related industries, using her tech expertise to guide clients unfamiliar with tech through complex legal issues presented by emerging technologies. She advises startups and business owners of established companies looking to scale, or grow their companies. 

In her two-part series, Innocenti-Placette frames the foundational decision every entrepreneur faces: How to determine the best legal structure for one’s startup. In part 1, she starts with the ‘why’ or founder’s purpose. It is an illuminating exploration of how the ‘why’ determines the legal ‘how’ for your business. Part 2 published March 2, 2018.

When I talk to founders in initial legal consultations, we often begin with purpose.  Why do they want to start this startup? Is it for innovation, income, or impact? The founder can pick only one, the most important one, the sine qua non, the purpose without which they don’t want to do it. When founders know their purpose, the path forward will have a lot fewer obstacles.

Innovation

This is my shorthand for what constitutes a “true” startup.  As defined by serial entrepreneur, Steve Blank, a startup is “a temporary organization designed to search for a repeatable and scalable business model.” If a founder’s purpose is innovation, the goal is to shake up an industry or create a new market.  A startup entrepreneur experiments with how to create and deliver a new product or service and how to monetize it. Think Facebook, a social media platform that is free for its users. A core part of Facebook’s early goals was the discovery of a way to monetize.

If your purpose is innovation, then you must be prepared. Startups only begin to generate revenue at scale.  That means it must depend on outside investment to pay for the work needed to identify a scalable model.  Much time is spent pitching to investors, fundraising, and sacrificing equity and control to reach the goal. Startups have audacious aspirations, as both founders and investors know success is a long shot and depends on failing fast and failing forward. Investors want to see experienced teams who have the skills to scale.

Startups with innovation in mind will need to choose the right entity form to accomplish that purpose.  It should allow for different types of ownership (for investors versus founders), equity incentives for employees, and appropriate tax treatment.

Business entities are created under state law, not federal, so selecting the state where the business is formed will also need to be a purposeful decision. Since innovation startups depend on investment rather than revenue, it helps to choose a state with which prospective investors are familiar and will prefer.

Income

Most entrepreneurs start a company to be their own boss and secure a place in the local market. This does not mean that the company created is not innovative.  The company may be doing some creative, impactful things.  It may even be a technology company.

However, that company is not working to discover a new business model, it’s working to execute on an existing successful model.  Managed service providers, Internet commerce storefronts, restaurants, plumbers, consultants, web designers, and others all use existing, proven business models.

Although these companies can become large, global, and impactful over time, they are not designed for fast scale. Their goal is to generate revenue from day one.  Rather than venture capital, the resources available for these businesses include savings, bank, and small business loans, and loans owners secure from friends and family. The best business form should be free from needless complexity, flexible enough to be tailored to the unique circumstances of the owners and produce a low tax burden.

Impact

Whether it’s rescuing abandoned cats and dogs, improving the quality of life of the homeless, or saving the environment, these entrepreneurs want a legacy of positive impact on the world. Typically, these founders think that a non-profit corporation is the right vehicle for them, but this category may also be a good fit for a for-profit entity.

A non-profit versus a for-profit business does not describe the legal business form but rather its taxation status. To obtain non-profit status, a business must comply with both state as well as federal requirements. Those requirements impose limitations on form, governance, and disclosures. For example, there are no owners of a non-profit. The founder may have a board position or may be the executive director, but the founder can also be fired by the board, holding no ownership interest in the non-profit or any work it was doing.

Non-profits are also required to disclose tax returns and their application for tax-exemption (including correspondence with the IRS related to the application).  Nor can the non-profit rely on “unrelated business income.”  If the non-profit generates revenue from an activity that looks a lot like business activity, that revenue can be taxed. A non-profit is meant to depend on donations, not revenue.

The Take-Away

Founders should focus first on purpose. Business and legal decisions gain clarity and the likelihood of a venture’s success increases. I’ve seen founders stumble because they didn’t align their true purpose with their startup approach or because founders disagreed on the business purpose. The initial gut check of figuring out if you really want to go down the path of a scalable startup (or a traditional business or an impact business) can prevent heartache, wasted years, and squandered legal fees.

The best first question your lawyer can ask you is, “What do you really want?”