What tech startups need to know today to succeed tomorrow
Five crucial legal and tax issues all start-ups should consider
Henry R. Luce, founder of Time magazine, described business as "an instinctive exercise in foresight." Foresight – the ability to thoughtfully predict what the future requires – is a key ingredient to start-up success. To see a future market demand for a product or service, and to satisfy that demand, is the essence of business success.
Along the way, however, start-up entrepreneurs also must have the foresight to make the right legal and tax decisions associated with their venture. Here are five crucial legal and tax issues all start-ups should consider:
1) Choice of Entity – what to consider when choosing a legal form of business.
Choice of entity is one of the first important legal and tax decisions in the life of a technology start-up. Although many start-up companies begin as sole proprietorships, start-up entrepreneurs should quickly form a legal entity in order to protect against personal liability.
Many start-up companies operate as a corporation or a limited liability company ("LLC"). LLCs generally are partnerships for tax purposes, meaning that profits and losses pass through to the owners without a tax on the business. LLCs also allow for customized economic interests and incentives.
Corporations, on the other hand, offer many protective and strategic benefits. However, one significant drawback of a traditional "C corporation" is double taxation at both the corporate entity and shareholder level. An alternative corporate structure is the "S corporation", which provides the benefits of a corporate shield while avoiding double taxation.
A start-up must also choose a state in which to form its business. For many, the predictability and sophistication of Delaware law is attractive, whereas for others, formation in the state of operation is sufficient.
2) IP Protection.
Intellectual property ("IP") invariably will be a start-up's most valuable asset, especially in the tech sector. As such, it is incredibly important that start-ups take the necessary legal steps at the outset to protect their IP from theft/infringement through proper legal safeguards.
In addition to asset protection, tax planning for IP should be on a start-up's radar. For example, if a technology start-up is successful in the US, it will likely, if not certainly, reap similar results internationally as well. Thus, all technology companies should assume that, if they are successful, they will become global in scale. That being the case, careful consideration of where to hold IP rights must be made. The best time to do this is before IP becomes highly valuable, as international corporate structuring with valuable IP can come at a staggering tax cost.
3) Issues relating to stakeholder investment.
Investor capital is the lifeblood of a start-up. Therefore, a start-up must carefully consider how it raises capital. For example, "debt verses equity" investment is a perennial issue that start-ups face.
For many, the burden and stress of debt leads them to raise capital through equity investment (i.e., the issuance of ownership interests to investors in exchange for capital). However, as start-ups begin to raise capital, they must carefully ensure that the issuance of ownership interests to new investors does not compromise the original value and vision of the start-up. For this reason, it's often advisable to carefully structure equity investment in a way that allows the founders of the start-up to retain control over the vision and mission of the company.
4) Long-term vision – how to get there.
For some start-up entrepreneurs, the ultimate goal is to sell the company to a large market competitor. In this scenario, the form and structure of the company should be attractive to potential acquirers by reflecting both practicality and sophistication.
Yet for most start-ups, selling is not the end game. Long-term, lucrative international growth is the objective for many visionaries. In these cases, as discussed above, international tax planning related to IP and other business attributes should be a top priority.
5) Tax planning – the earlier the better.
Careful tax planning in a start-up's early days can substantially contribute to the financial upside, and ultimately to the material success, of a start-up.
In the start-up world, investment capital is king. Expansion and development require cash, and lots of it. In today's global economy, international growth is a standard aspiration. As discussed above, start-ups can experience significant tax savings if they properly structure their operations. A lower tax bill means more capital available to reinvest for further expansion and development, thus reducing the need for additional third party capital (which would further dilute the founders' ownership percentages in the company).
While some may think tax planning is too costly in the early stages of development, in reality, a young company should not ignore this critical planning opportunity. Having the instincts and foresight to see the advantages of tax planning at the early stages of a start-up is critically important to your company's success.