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High Tech Company Formation Requires Careful Consideration

Posted in Web/Tech

By Julie Garcia

Determining the choice of entity for a high technology company can be a daunting task. In general, careful consideration should be given to the choice of entity when forming any type of company; however, high technology companies have additional issues that may alter the decision regarding the choice of entity. Generally, raising capital to fund the research, development and manufacturing of the company’s products may determine the type of entity best suited to the needs of the new company. Typically, the type of entity will be either a corporation or a limited liability company. If a corporation is chosen, the decision as to whether the corporation will be a Subchapter S Corporation will also need to be made. Partnerships and sole proprietorships are not commonly chosen as the type of entity for high technology companies primarily due to liability concerns. Corporations and limited liability companies each have pros and cons that must be carefully considered for each situation when determining the type of entity.

Corporations have been in existence for a long time and generally have a well established base of both statutory and case law guidance. Although each jurisdiction may have different rules, regulations and cases that govern corporations and some jurisdictions may be more favorable to corporations than other jurisdictions, general corporate principles exist that can be examined when determining the type of entity to use for a new venture. If a corporation is chosen, the jurisdiction for formation should be carefully analyzed to determine the most advantageous jurisdiction. Many businesses prefer corporations because of the long standing history and general feeling of comfort regarding issues that are important to the founders of a business, such as liability protection and corporate governance. Financing a corporation is a path that has been well trodden and individual strategy based on the company’s circumstances and business plan becomes the focus of financial planning. If a high technology company plans on funding its operations through venture capital, formation of a corporation is generally preferable to other types of entities due to general familiarity with the corporate structure and a long history of investments into corporations by venture capitalists, angel investors and institutional investors.

A Subchapter S Corporation, generally referred to as an S Corporation, is a variation on the corporate entity. An S Corporation provides the same general protections as a corporation and is subject to the same corporate governance rules and regulations as a corporation; however, S Corporations generally provide a tax benefit to the company. An S Corporation is subject to limitations on the number and type of eligible shareholders. An S Corporation is limited to 75 shareholders (subject to specified counting considerations, for example, husband and wife) and, in general, only individuals and not entities are allowed to be shareholders of an S corporation. In addition, shareholders cannot be nonresident aliens. There are a few exceptions to the rule denying entities as shareholders, however, the exceptions generally relate to trusts formed for estate planning purposes controlled by a shareholder. Another corporation is generally not allowed to be a shareholder of an S Corporation which may create an issue if the funding of the company depends on institutional investors or venture capitalists. Most high technology companies obtain financing from venture capital funds, institutional investors or angel investors which are generally formed as entities that are not allowed to be shareholders of an S Corporation. Although an S Corporation is generally favored by high technology companies that will be funded by the founders, a high technology company that plans on obtaining significant funding from external sources will generally not be eligible to become an S Corporation.

A limited liability company is a newer type of entity, as compared to corporations, that has gained wide acceptance and is the preferred choice of entity in certain industries and/or transactions. A limited liability company provides a lot of the same general protections as a corporation, and although an analogy can generally be made to the rules, regulations and case law governing corporations, significant areas of limited liability company rules and regulations have not yet been tested in the courts. Although capital can be raised for a limited liability company, the general structure of a limited liability company may impose an administrative burden if a significant number of investors are projected. Although a limited liability company operating agreement may allow for different classes of membership interests and ultimately may allow for more creativity in structuring the investment transaction, the lack of court and statutory guidance on a number of issues deter many smaller high technology companies from choosing the limited liability company structure.

High technology companies face a number of issues that a traditional company may not face due to concerns with its intellectual property protection and concerns relating to financing of the company. The traditional model for a high technology company seeking funding from venture capitalists or institutional investors is generally to form as a corporation and sell stock to raise capital. Although corporations may have different classes of stock and become complicated, the general nature of corporate governance may be more structured than a limited liability company and provide a better framework to handle a large number of investors. Although an S Corporation may be preferable, particularly from a tax perspective, it may not be a viable option if the company intends to seek investments from venture capitalists or institutional investors formed as entities to fund its research, development and product launch. A limited liability company, although preferable in a number of industries, may impose limitations on a high technology company that become burdensome and outweigh the tax advantages as the choice of entity. Careful consideration to the business plan, future financing needs and general operating structure of a new business venture should be made prior to the formation of a high technology company.