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Ask HN: running startup as a sole proprietorship until you receive funding.

8 pointstrumbo8 comments

So I am entering an agreement with someone who is starting up a company. He asked me to work for the company in exchange for a percentage share, and the agreement states that until the venture receives funding it will be run as a sole proprietorship to save on legal fees. Is this a good idea? Are there any risks, for me or for the startup? I'm not familiar with the legal aspects of business, so I'd really appreciate the guidance.

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I'm not a lawyer so don't take this as legal advice, but here's my understanding:

I don't think that you are able to give a percentage share of the company with a sole proprietorship. By definition it is owned by him alone and if you transfer the IP to the company, then you are transferring it to him and you have no stake. I am not sure what effect a contract would have, but I think he would be in a position to do what he wanted with the company and you'd have no official stake. For example, what if he sells the sole proprietorship before he gets funding?

As an LLC, I know that you can specify shareholders. I have seen people do this for family-and-friend investors. Although a full-fledged startup typically runs as a corporation.

If I were you, I would insist on creating a corporation (or at least an LLC). From what I've seen it only costs $1,500-$2,500 for an affordable lawyer which isn't really -that- much if you're serious about building a business here. You can even do LegalZoom though it's not typically recommended, but you can just re-do your corporation when you get funded. But the point is that at least your interests will be protected until then.

Personally I'm running as an LLC because I'm not expecting to get funding. If I was actively looking for funding I would have just started a corporation.

Can you explain why it makes a difference to run as an LLC if you are not expecting funding? My company is expecting funding. So should I insist on creating a corporation instead?

VCs will insist, as a requirement of the raise, that you change your corporate structure to a C-Corp. This is because LLCs pass-through income to the shareholders. The VCs' limited partners may have severe problems with this - for instance, a foreign entity might suddenly have US income, forcing them to file a US tax return.

In other words, if you know you're raising money, you might as well structure the company correctly in the first place, since you'll just have to pay lawyers to redo it when you raise.

The big risk in going from a sole proprietorship that you don't own to a corporation is to you personally, not to the startup. I would only consider such an arrangement if my co-founder was compelled to follow through on the deal - for instance, if you retained full ownership over the IP you created until the company was properly structured. But why set up a Mexican standoff when you can just do it right the first time? It's not the hardship your co-founder is making it out to be.

This is a bad idea at best and a red flag at worst. It costs very little to set the paperwork up properly. A sole proprietorship is just that - he owns everything and owes you nothing without some strange contract promising you equity in a business that doesn't exist yet. And if you're going to go through with the hassle and expense of setting up a contract with his sole proprietorship, you may as well just set up a proper entity.

This is such a bad idea that it's not worth talking to a lawyer about. If he won't do it right, don't do it at all.

(The right answer is probably an LLC. They're cheap to set up, flexible, and pretty easy to convert to a C corp should you go the institutional investor route.)

I don't quite understand this and maybe I'm reading it wrong. But if it is a sole proprietorship he owns it outright and you're an employee and you have nothing but a verbal promise of a foot massage and an ice cream later.

If he's saying you have a percentage now, then it isn't a sole proprietorship. It is a general partnership. The default result when two people go into business together is that they've made a general partnership. There are an elaborate set of laws that fill in the gaps if you don't have an explicit agreement on profit allocations or any ther aspect of your deal.

All that aside this shows sloppy thinking on the part of your friend. Be careful.

IAAL.

> He asked me to work for the company in exchange for a percentage share, and the agreement states that until the venture receives funding it will be run as a sole proprietorship to save on legal fees. Is this a good idea?

Let's find out what he really thinks about this arrangement.

Ask him to switch roles. In other words, the company is your sole proprietorship and he gets whatever he expected you to take.

If he won't go for that, why should you?

If he will and you decide to go through with this arrangement, make the decision as to roles using a coin flip or some other random process. If he won't agree to that, he was bluffing.

It comes down to trust, because legally, I don't think your bases would be covered. I'm in a similar situation, working as a consultant. But I've known the CEO for several years and trust him. We are in the final phases of adjusting the LLC and giving me shares. I've been willing to defer this for a while since there is a decent amount of costs involved setting this up correctly so I don't get taxed on the shares.

Come to think of that, this could be a serious issue for you. Lets say that everything goes smoothly and you do get funding. At this point you get shares, you will have a taxable event based on the value of those shares. This is true even if you are never able to sale the shares. You still owe taxes on them. If you get your shares now, the valuation of the company will be much less than later and therefore the tax you owe will be much less.

If you don't trust this guy a lot, I'd push to get it set up correctly. Or at the minimum have a lawyer draft up an agreement and talk with an accountant to figure out the tax implications of this.

Ask a lawyer.

But before you do, read up on the sole proprietor model:

http://www.sba.gov/smallbusinessplanner/start/chooseastructu...

It would appear to be the same as what we in the UK call sole traders - the most important point is that there is no real legal distinction between the owner and the business itself. Not in terms of assets/debts, anyway. This is the kind of business that loses the owner's house if it all goes to hell.

I don't know how this affects relationships with employees - even if there is such a thing under this model - and I really don't know how it affects the notion of equity. In particular, 'a percentage share' of what?

You want to talk to a lawyer about whether what your partner is proposing even makes legal sense, as well as whether it is advisable.

My hunch would be that it is not a fantastic idea. Go see a lawyer (or even a business adviser - your city may have some that don't cost anything).

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