One of the first and most important issues entrepreneurs face is what type of entity they should use to form their new company. Most commonly, this comes down to a choice between a limited liability company (LLC) or a corporation. These two types of entities differ significantly in how they are governed.
All owners of a corporation own shares of stock and are called shareholders. A shareholder’s proportion of ownership is calculated by how many shares of stock she has relative to the other shareholders. The shareholders of a corporation elect a board of directors, which has the ultimate managerial control over the company. Shareholders may also be directors, but there is no requirement that they be. All major decisions of a corporation must be made by the board and approved by a vote. These decisions must be documented as formal resolutions, and minutes of meetings of the board must also be taken.
A corporation’s board of directors delegates the day-to-day management of the corporation to officers, who are also responsible for carrying out the decisions of the board. There is no requirement that someone be a shareholder or a director in order for them to be an officer. As such, all three branches (shareholders, directors, and officers) could consist of completely different people, although there is usually some degree of overlap.
Corporations are governed by a certificate of incorporation (sometimes called a “charter” or “articles of incorporation”) along with a set of bylaws, which set out voting procedures and board election. Further, there can be one or more shareholder agreements, which may set forth the rights shareholders have (e.g. restrictions on transfers, options, right of first refusals, etc.). Corporations are typically, but not always, required to hold annual shareholder and/or board meetings, even if there are no important issues to discuss.
In summary, corporations are governed is in a formalistic and systematic manner. This type of governance establishes a template for decision-making procedures and can be beneficial if a corporation has many shareholders and/or directors. The disadvantage of the corporate governance formalities is that the formalities can be overkill for a small business that has just one or a few shareholders.
Limited Liability Company Governance
Owners of an LLC are called members, whose portion of ownership is often measured in percentage interests (although LLCs can emulate corporations by issuing units of ownership, which are similar to shares of stock for a corporation). Limited liability companies can be governed directly by members, as partnerships are often governed, in which case members vote to approve or reject major issues and decisions. Individual LLC members can often act as an agent of an LLC and sign and execute contracts. It is also possible for members to delegate decision making powers to non-members (something that is seldom done with member-managed LLCs).
Limited liability companies can also choose to be manager-managed, in which case members have no governance rights over the company but have the power to elect managers, who then have the final decision-making authority with the company. Some states have legislation that allow for board-managed LLCs that parallel the governance structure of corporations. With board-managed LLCs, the members elect a board of governors/directors/managers, which manages the LLC like a board of directors would manage a corporation. Even in states that do not have legislation allowing for board-managed LLCs, a corporation-like structure can be emulated by having a few managers act as the board of the LLC, and who delegate day-to-day decision-making authority to officers.
Limited liability companies are governed by a certificate of formation (sometimes referred to as the articles of organization) and an operating agreement, which is essentially a comprehensive contract between the members (and often managers, too) that covers financial rights (e.g. division of profits, losses, and cash flow matters), company governance matters like manager election and voting issues, and rights between the members, such as restrictions on transfer of ownership and/or rights.
The primary theme of the way LLCs are governed is flexibility. Typically, the parties can organize an LLC however they wish; they can govern it in a structured manner as a corporation is governed, run it informally, or operate some kind of hybrid form. LLCs permit a high degree of creativity in structuring a company, which is often what makes LLCs so desirable for small businesses.
Some Quick Tips:
Here are a few general tips for deciding whether to go with an LLC or corporation to form your new company. Please note that these tips only consider governance issues—there are many other issues to consider, including taxation, asset protection, and whether or not you intend to seek outside funding.
An LLC is often the best type of entity for companies with only a single or a few owners, as it is the easiest organization form to manage. The owner or owners can operate an LLC in almost the same way they would manage a sole proprietorship or partnership (except LLC members must ensure they do not commingle company and personal funds, an issue not of concern to a sole proprietor). Further, LLCs do not require annual meetings that the member(s) must attend, nor are there any required formal resolutions.
For companies that have many owners but only one owner operates the company, an LLC is again the best option. In this scenario, the company would be best off as a manager-managed LLC and the members would either elect a manager or one would be appointed in the operating agreement. Such a structure is similar to a limited partnership, except the manager is not liable for the debts of the company like the general partner in a limited partnership would be.
For a company with a significant number of decision-makers or owners, a corporation is commonly the best, as the structured nature of a corporation provides predictability and organization. Again, the owners may also consider a board-managed LLC (e.g. if they prefer a corporate structure but wish to be taxed as a partnership, or if they desire the asset protection benefits of an LLC) if their state allows for such.
There are many more considerations to take into account when you are starting a business. Please also note that entity selection needs to be based on your specific business needs. It is important to speak with a business attorney and/or accountant prior to forming a business entity to ensure you are set up for optimal growth and success.
About the Author:
Dallas P. Verhagen is a business attorney and a partner at Verhagen | Bennett LLP. To learn more about Dallas, please click here.
For questions or comments about this post, please email Dallas directly at: Dallas@VerhagenBennett.com
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© 2017 Dallas P. Verhagen — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.