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Business formation 101 for SaaS companies

Starting a Business

Business entities aren’t one-size-fits-all. But, several options benefit and protect SaaS founders and their companies. Whether you need to make Venture Capitalists happy, operate with a board, or avoid paying corporate tax – there’s an option that’ll suit.

Note: we aren’t lawyers or accountants, but here are some basics to point you in the right direction.

The basics

Each state has different formation rules based on the business entity type. There are various formation fees, dues, tax regulations, etc. in each state. Check out this map to view specific entity information for your state.

You don’t necessarily have to form a business in the state you reside in/are headquartered in – although, it may be beneficial in the long run to register within your state.

Entities for SaaS startups

Limited Liability Company (LLC)
Most business founders I’ve come across register LLCs (at least in the beginning). Limited Liability Companies **are great because they protect your personal assets. Example: if your company was ever to be sued (heaven forbid) or even go bankrupt, your personal home, credit, and vehicles wouldn’t be on the line.

The best benefit of being a Limited Liability Company is that you avoid corporate tax. With a LLC, your income will pass through the company to your personal tax records. You’ll only pay tax on the net profit of your business, and you’ll only pay tax on that amount the same way (and at the same rate) you pay personal taxes.

Other benefits of a LLC are that you can avoid all the bureaucracy of being a C Corp. You’ll avoid the headaches of writing corporate bylaws, choosing and listening to a board. Instead of wasting time with all the bureaucracy, you can register your company and launch your product.

S Corp
A Subchapter S Corporation is a mix between an LLC and a Corporation. It’s usually an election, meaning you first form a LLC, and then you file a S Corp form telling the government that you want to be a S Corp.

As a S Corp, you get all the personal asset protection as with the LLC. You also have the advantage of pass-through taxes like with a Limited Liability Company (paying tax on net profit at the individual level), but you also have stock to give to up to 100 shareholders.

With such stock, an S Corp might allow for investment from an angel investor or two, but VCs will still prefer a corporation.

C Corp
Corporations require corporate bylaws, a board, recorded meeting minutes, etc. Always use a meeting minutes template to keep better track of the essential information! And, you’ll pay corporate tax rates since your income won’t pass through to your personal income as it would under an LLC or S Corp.

C Corps also protects the personal assets of founders and shareholders. Another benefit of a Corporation is that you can grant investors (particularly Venture Capital firms and accelerators/incubators) preferred stock options – which, in addition to a solid valuation, is most likely what they’ll want. Preferred stock is like a hybrid of a stock and a bond – it offers a better income prediction for holders.

You’ll need to be a C Corp when it comes time to sell or IPO. This is because as a C Corp, you’ll have plenty of stock to give away and won’t be limited to 100 shareholders like a S Corp. Investors like Delaware C Corps as the state is a tax haven with all kinds of sweet tax breaks. A C Corp is also the best way to give your employees stock.

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Starting as a LLC and switching to a C Corp

Many companies start as LLCs as it’s quick to get off the ground and require a little extra work like writing bylaws (yuck) – giving you more time to prep for launch. When you find VCs sniffing around or decide you want to sell some stock, then you can always switch your entity from an LLC to a corporation. Make sure you file a short-year tax return for the LLC once it’s dissolved.

A little advice

Before you make any of these decisions, you should speak with your accountant. If you don’t have an accountant, get one, AT LEAST consult with one about how you’ll be taxed and what formation might be best for you. Before you make any switches (from LLC to C Corp or whatevs), you should absolutely speak with a corporate attorney.

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