Starting your own tech company can be an exciting but challenging venture, and there are several factors you must consider, such as choosing the right business structure. There are several steps and aspects that you also have to put into perspective before deciding on the best business structure that's fit for your tech startup. Moreover, the one you should settle on is critical to the operations and success of your startup.
In addition, while other aspects, such as liability, taxes, and capital, play a crucial role in deciding on the right business structure for your tech startup, ultimately, the final decision lies in your hands. Here’s how you can make the right choice:
Understand The Different Types Of Business Structures
You can choose from many business structures depending on your goals and the direction you want your tech startup to take. However, it's essential to note that tech startups require a lot of capital, especially if they involve the Internet of Things or artificial intelligence.
Business structures are crucial because they represent the legal framework in a specific jurisdiction. This means that the one you choose has to reflect the laws of that country in terms of operations. In addition, the business structure can also affect how your startup engages in activities such as getting capital and liabilities on financial and tax obligations.
Other aspects of the startup that can be affected by the business structure you choose include:
- Daily business operations
- Means of raising capital
- Tax obligations.
Here are the business structures you can consider and their advantages:
1. Sole Proprietorship
This is the easiest business structure you can create for your tech startup because it's owned and operated by one person. A sole proprietorship is easy to develop because there's no need for registration, but you can get a certificate for which you'll have to pay. It'll be a form of reserving the rights to a particular trading name.
Another aspect to note with this business structure is that the company won't be a separate legal entity from you as the owner. The company's profits are combined with your income to determine your tax obligations. Your returns as the company owner would be inclusive of the business's earnings and expenses. Therefore, this business structure is effective for minimal-risk small companies for which you're comfortable raising capital.
Some of the benefits of creating a sole proprietorship are:
- You'll have full control over the operations and decisions of the tech startup.
- You can file taxes once because the tech startup's income and expenses are combined with your income tax returns.
- You can get larger tax refunds because the revenue generated can offset the tech startup's losses.
- It's easy to create because of the minimal paperwork.
You can weigh these advantages over any drawbacks to help you decide if a sole proprietorship would be the best business structure for your tech startup.
Another way to structure your tech startup would be through a corporation, which is a distinct legal entity from its owners. Unlike a sole proprietorship, this business structure is more complex and expensive. A corporation is regulated by additional laws and regulations, especially taxes.
There are two primary classifications of corporations based on tax status; C corp and S corp. You can take advantage of the s corp tax loopholes when considering the right business structure for your tech startup.
The difference between a C corp and S corp are as follows:
- S Corp
This business structure functions by transmitting the business profits, losses, deductions, and credits to shareholders to minimize its tax liability. When filing taxes, your corporation has to report all income, expenses, credits, and deductions. Eventually, the shareholders would pay the federal tax income through individual tax rates on their tax returns. This ascertains that the startup avoids a case of double taxation.
Here are the advantages of S corps:
- Shareholders can sell their shares without tax obligations because the corporation is a distinct legal entity.
- Shareholders can't be personally liable for the debts and liabilities of the tech startup.
- The entity can avoid double taxation because only the shareholders and owners are subject to tax obligations.
An S corp is a favorable business structure if you want to avoid double taxation, especially when starting.
- C Corp
Your tech startup has to file its tax returns in this business structure. The earnings would be taxed at the corporate rate of the jurisdiction within which it's paying taxes. In addition, any business earnings transferred to owners as shareholders would be taxed as personal income. This means that a C corp is eventually subject to double taxation.
Here are the advantages of C corps:
- The tech startup can raise capital by selling stocks and issuing shares to its shareholders, helping it grow.
- The tech startup is liable for its liabilities, protecting the owner's personal assets.
- The tech startup can write off employee benefits, such as insurance because it's already subject to double taxation.
Additionally, a corporation would be appropriate for your tech startup if you need debt protection, gradual development trajectory, and personal liability. It's also easy to raise capital through external investors and shareholders through a corporation, which is crucial to a tech startup.
3. Limited Liability Company (LLC)
This is another business structure that you can consider for your tech startup. One of the aspects of this structure is that it's a separate legal entity from its owner, making it liable for its debts and legal actions. In addition, the administration of an LLC is flexible, and you don't necessarily need a board and executives to run the daily operations.
Here are a few advantages of creating an LLC for your tech startup:
- The cost of establishing an LLC is considerably low and affordable.
- You can include the company's financial statement in your tax return filing.
- The tech startup shall be liable for its debts and legal obligations.
Although an LLC can be a great business structure for your tech startup, it can limit capital raising.
You can also opt to get into a partnership, an agreement between two or more people to run a business to make a profit. There are two types of partnerships for you to choose from:
- Limited partnership: This structure involves having general and limited partners. The minimum number of partners is two. Ideally, the limited partner is an investor who doesn't run or operate the business. In contrast, the general partner takes responsibility for the partnership's obligations and manages the business's daily operations.
- General Partnership: In this structure, a minimum of two partners can be responsible for managing the business and ensuring that all obligations have been paid off.
Some of the advantages of getting into a partnership include the following:
- Raising capital is easy because both partners would be funding the tech startup.
- The business model is easy to create, with less paperwork, and the partners don't have to adhere to the same standards as in other structures, such as an LLC.
- There's no obligation to file business tax returns because the partnership doesn't have to pay income tax directly.
- The partners can share responsibilities for the operations of the tech startup based on their skills and expertise.
When considering getting into a partnership, it’d help to find a partner or partners who share your vision for the tech startup.
Factors To Consider When Choosing A Business Structure
Below are crucial factors to take into account when selecting a business structure.
It'd be best to consider how much capital you have or plan to raise before incorporating your tech company. The capital investment you have is crucial to the effective and efficient running of the tech startup because it also affects the availability of resources. For instance, if you're establishing a sole proprietorship, you'll have to use your money as capital.
On the other hand, if you incorporate the tech startup as a corporation or LLC, you'll have access to equity and debt financing. You can get equity financing by selling shares to shareholders, while debt financing can be accessed through financial institutions, such as banks. Tech startups focusing on artificial intelligence and cybersecurity are expensive to set up and require a lot of capital, which you can source from investors if you have the right business model.
Some business structures allow you to maintain control over the tech startup, while others might require you to relinquish the administrative operations to a board or executives. Before settling on the right structure for your tech startup, you must decide how you want the business to be controlled. For example, creating an LLC or a sole proprietorship would be best if you want to maintain control over the tech startup.
It'd help if you also considered the liabilities of the tech startup before deciding on the most appropriate business model. For instance, structures that are distinct legal entities protect your personal property from the debts and legal obligations of the tech startup. On the other hand, business structures with no separation of legal entities, such as a sole proprietorship, make you personally liable for all the debts and legal obligations of the startup. This puts your personal property at risk.
4. Tax Obligations
The business model you choose for your tech startup has great implications for your tax obligations. While some models, such as a C corp, can subject you to double taxation, others, such as and S corp, have tax loopholes for small businesses that you can take advantage of. Thus, it's important to consult a tax expert or attorney to help you understand the tax obligations of each business structure you're considering for your business.
The objectives and needs of your tech startup can help determine how you'll manage the operations and how many people you need. If you adopt a simple structure, you'll need a few people to manage the business. On the contrary, the more complex the business structure gets, the more people you'll need to operate the business.
The business model you choose for your tech startup is critical to its success. Before considering business models, you must first determine your objectives and the available resources. In addition, the business structure you choose should give you options to raise capital as the tech startup grows. If you need help with the best business model for your business, you can consult an attorney who'll explain the different structures and their suitability to your goals and needs.