Hi Adam,
I think you are asking two questions: 1) what sort of entity would best attract a VC/angel, and 2) what choice of entity would be best to allow the employees to be rewarded 20% of the prfits from any successful venture. You have obviously reviewed the various potential entities - but I woud highly suggest you seek professional advice from both an attorney experience in start-ups and VC/Equity investments as well as a CPA for the tax implications.

The above given, there is a trend for small businesses to set up as an LLC which has tax advantages to a C-Corp (double taxation - on the entity and the shareholders) and without certain limitations on number of investors/type of investment imposed on an S-Corp. Partnerships may be a little more complicated and may require setting up two entities - gerneral partnership and limited partnership to insulate non-managing partners from liability. Please note that the beneficial tax treatment of a flow-through entity (S-corp, LLC, partnership) may be disqualified (i.e. taxed as a C-corp) if for example as an S-corp you have a shareholder who is a corproation, partnership, or LLC or has more than 100 shareholders or an LLC may be disqualified if it has any publicly traded equity interests. So you really need to consult with a legal/tax professional and depending on the entity you select, understand the limitations of each type of entity.

Re: question 2) on rewarding employees 20% of any profits on the venture and rewarding the owners/investors with 80% of the profits, that is a deal you will have to negotiate with the VC/angel. Generally, a VC will want at least part of its equity investment in a debt instrument rather than stock - since if the start-up never makes they have some standing a creditor to get more of their original investment back versus holding some relatively worthless stock. Thus, you may find a VC/angle willing to take some stock, with a debt position up to the limit of their investment and then agree to split any profits. Using your example, if the VC invested $1M, they may take a combination of stock/debt to cover their $1M investment. If the company then sells for $2M, they would receive $1M investment, plus $800K of the split and the employees would receive the other $200K.
If rhe VC is really securing its invenstment, then I would recommend and split more reasonable to the employees, but I think you get the idea on how the splitting of profits above the original VC investment would work.

I hope the above is of help.

Regards,

Daniel

Disclaimer: The above does not consititute legal advice nor deos it establish an attorney-client reltionship.

posted October 7, 2009

Generally - remember that employees are not owners unless they own stock. They receive their compensation through salary or bonuses. After expenses, including salaries, the net may be distributed to the shareholders (owners). If you really are trying to do this split you may have to look at doing it as an LLC. Of course check with an attorney or CPA for your exact situation.

posted October 7, 2009

I concur with the above general responses, but will answer some of the specific questions. And of course, the advice you are asking for is the bread and butter of attorneys and accountants who focus on startup companies, so you'll get the best advice tailored to your needs by engaging these professionals.

That said... VCs and institutional Angel groups (which really try and function like small VCs) generally prefer to invest in corporations. You can sell them on LLCs, but it's going to be a little more work and expense to structure that deal. They also prefer to invest through either convertible notes or preferred stock. Individual and less sophisticated Angels are more likely to accept equity on par with the founders and are more willing to invest in LLCs.

On the flip side... you have to go with the LLC if you want to maintain flow-through tax treatment while at the same time bringing in institutional investors or issue preferred equity (either one would blow your S Corp status, but won't affect the partnership tax treatment of an LLC).

Stock option plans are easy to do with a corporation, and most attorneys who work with startups have stock documents. Not as many attorneys are familiar with equity incentive plans for LLCs, usually done through a Unit Appreciation Rights Plan, so this is something to quiz your potential counsel on. A simpler and less utilized tool is simply having change of control bonus agreements in place. $X to the employee upon a sale event (or some percentage of sale proceeds after paying transaction expenses) if they are still employed at the time of the transaction, done through a letter agreement or part of their employee agreement.

VCs and Angels don't typically care exactly how you structure these incentive plans so long as they are clean and easy to identify who gets what. They will care more about what percentage they will be getting, not how the founders agree to share the remaining portion. They do want to make sure that key employees are properly compensated so that they stick around post-transaction.

If you want reading material, check out the link below.

Links:

• http://www.amazon.com/Term-Sheets-Valuations-Intricacies-Venture/dp/1587620...

posted October 7, 2009

Dear Adam,

As someone who's represented dozens of startups, closed probably 100 venture deals, and cleaned up too many small companies to count, there is in fact a right way and wrong way to do this.

The best way, if you're planning on a software company that will be seeking traditional VC money, is to form a Delaware corporation, taxed as a C-corp, that owns and develops the IP (the software). That structure works for VCs without creating problems.

Here are some quick points:
1. s-corp or LLC taxed as a partnership means that there can be leftover tax liabilities. It's not worth the trouble to diligence them, so you'll just end up either killing the deal or hopefully putting the existing entity behind a chinese wall and having it be a shareholder in a new -- yep, Delaware c-corp.
2. profit sharing with employees can be done in many ways, but stock options are straightforward and well-understood both by VCs and software engineers. There's a plethora of information available to everyone on how to value, structure, exercise, and pay tax(!) on them.
3. ownership, management, and governance can be turned into sticky problems. Using a standard structure like the DE c-corp helps everyone focus on the actual issues instead of the wrapper.

The only realistic alternative, if you have substantial other income that could be sheltered and sufficient skills and funding to bootstrap for a while, would be to use one of the alternate structures (LLC w/partnership taxation) deliberately so as to harvest tax losses while you are developing to the point that you will seek VC funding and then execute the chinese wall maneuver I described earlier.

Think of it this way: it's hard enough to have a great idea, start executing it, interest a VC, and close funding. Why would you let something like an uninformed legal entity structure jeopardize your deal? As you can tell, I've taken companies down several of these paths. Some are way better than others.



Thanks,

Rick Colosimo

Links:

• http://www.thoughtstorm.com/
• http://www.rickcolosimo.com/

posted October 7, 2009

You have some nice answers here, but I suggest that you hire a local lawyer familiar with this area of the law, rather than relying upon advice on the internet in response to a very short synopsis of your issue. I believe you will find it is money well spent.

posted October 7, 2009

posted October 13, 2009