If you are thinking about launching a startup, or have already done so, you may be grappling with the question of whether, and when, you should create a corporation, LLC or other limited liability entity for your business. Perhaps you are aware that some startup founders begin without creating an entity, and you are now wondering if you should do the same.
Although I understand why founders are sometimes reluctant to spend time and money setting up an entity when they are not even sure if their business will be viable, I generally advise clients to create an entity as soon as possible in the startup launch process. This is because the cost of creating an entity is usually small, the time spent on this step is often minimal, and the benefits of creating an entity can be substantial. Moreover, while founders may think that, by doing nothing, they have postponed entity creation, in many cases they have, in fact, unknowingly created an entity already, just not the one they would have selected, had they taken the time to consider their options carefully.
As many of us have learned at some point in our lives, not making a decision can, itself, be a decision, and the startup world is no exception to this general rule. Under the partnership statutes of most, if not all, states (including both Wisconsin and Illinois), whenever two or more persons, as co-owners, carry on a business for profit, they are (with limited exceptions) deemed to have formed a general partnership unless the co-owners have formed another entity authorized by state law to carry on their business. In other words, in most, if not all, states, if your startup has more than one founder, you have probably already created a general partnership for your startup, unless you have taken all of the legal steps necessary to turn your startup into something else.
Is it bad to be a general partnership? Let’s just say you would probably not have selected this entity, if you had taken the time to consider your options carefully. This is because, unlike most other entities, general partnerships do not protect their partners from personal, legal liability for the actions and obligations of the general partnership. If, for example, an angry vendor or unpaid consultant sues your startup, then you, not just the partnership, will be personally liable for paying your share of any judgment against the partnership.
In addition, as a general partnership, many of the rights and obligations of your business and its partners will be determined by your state’s general partnership statute (unless you have a written agreement to the contrary), and state partnership law, in many cases, will not produce the result you would have selected on your own. For example, while you probably do not want your cofounder to sign a binding contract on behalf of your business without your knowledge, under many state partnership statutes, your cofounder would have the authority to do this without your consent. This means that you would be liable for obligations arising under a contract signed by your cofounder, even if you knew nothing about it and never would have agreed to it.
To avoid this risk of creating an “accidental general partnership,” it is usually a good idea to set up a corporation, LLC or other limited liability entity as soon as you start a business, if your business has more than one founder. As an added benefit, the process of creating an entity will force you and your cofounders to make some important decisions right away, such as how much equity each of you will have in the new entity and whether, and when, the company will be able to repurchase that equity, if a founder leaves. Although it is often difficult and uncomfortable for cofounders to discuss these issues, especially if they are long-time friends, in my experience, it is always easier to discuss these issues when a business is worth $0 than when it is worth (or looks like it will be worth) $100,000,000.
Now, if you are a solo founder, you may be thinking that you can postpone the creation of an entity because one person, working alone, will never become a partnership, since a partnership, by definition, requires at least two people or entities. If you are thinking this, however, you are mistaken. Although, as a solo founder, you do not face the risk of becoming an “accidental general partnership,” you do still face the risk of being personally liable for the debts and obligations of your business, and, even as a solo founder, you could face substantial liability because of an angry customer or because someone slips and falls in your office. The easiest way to limit this risk is to create a corporation, LLC or other limited liability entity for your business. Consequently, I generally make the same recommendation to my clients who are solo founders that I make to my clients who form businesses with multiple founders, i.e. set up a corporation, LLC or other limited liability entity for your business as early as possible in the startup process. While such an entity will not completely eliminate all possible risk of personal liability for the debts and obligations of your business, it will reduce that risk substantially. Consequently, spending a little time and money to set up a limited liability entity of some kind (whether it is a corporation, LLC or something else) is, in my opinion, an investment well worth making.
This article was written by Janice L. Gauthier, Esq. Ms. Gauthier has an A.B., cum laude, from Harvard University and a J.D, cum laude,. from Harvard Law School. She is a startup lawyer and the owner of The Gauthier Law Group, LLC, a boutique startup law firm in Milwaukee, Wisconsin, that represents founders, entrepreneurs, startups and early-stage businesses in Wisconsin and Illinois. You can contact Ms. Gauthier at 414-270-3855, ext. 101 or by email. To learn more about Ms. Gauthier’s background and experience, visit her Google or LinkedIn profiles.
© 2014 The Gauthier Law Group, LLC. All rights reserved.
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