Structuring Your Startup as a Partnership? Think Again
There will come a time along your entrepreneurial journey when you will have to decide on the legal structure of your startup. If it’s just one person involved, the choices are generally limited to sole proprietorship, sub-s corp or a c-corp. But when more than one person is involved in the startup, there are more options — and more risk. In working with founders, I often find that this decision is made in haste, and not seen as important as other aspects of starting up — like acquiring your first customers or securing funding. However, the choice you make will determine the risk you expose yourself to as your business succeeds or fails.
Partnerships
A common business structure for businesses in today’s climate are partnerships. Typically, the partners work on the business together and own their individual shares and debts. Entering into a partnership is generally pretty simple and cheap. The ease of navigating a partnership often makes it seem like the smarter option in the early days of running a business, especially when you’re bootstrapping.
However, there are many notable downfalls to the classic business partnership that many founders don’t consider. If you and one or more cofounders are trying to decide how to structure your startup and are considering a partnership, you should pay close attention to this article.
Tax matters aside, in my opinion, the single greatest downfall to a partnership is shared liability. In a traditional partnership, each partner is individually liable for the debts, expenses and actions of the other partner. In a partnership, should your company fail, business owners need to turn to their personal assets or lines of credit to cover expenses, debts or legal costs. And if one partner racks up large sums of debt outside of the company, the assets of the partnership are up for grabs.
Even worse, should one of the partners become the target of a lawsuit, the assets of the partnership and of both partners can be at risk. That alone makes a straight partnership worth not considering as a way to structure your startup.
Operating or scaling a partnership can also be difficult. Each partner is responsible for the decisions of the other, meaning that one partner can make faulty decisions at the cost of the other. This, of course, is a breeding ground for conflict. Should the partnership go sour, it means buying out your partner’s stocks or litigation.
Lastly, if your goal is to seek outside funding, you’re out of luck with a partnership. There isn’t a credible investor I’ve ever seen who would consider investing in a straight partnership.
LLC (Limited Liability Corporation)
If you want to keep things simple, instead of a corporation, you might consider a Limited Liability Corporation. As the name suggests, corporations allow business owners to remove their individual liability from the business. Corporations are able to function as independent business entities and are solely responsible for all debts and liabilities within the business.
LLCs are also beneficial for business owners for a slew of other reasons. Corporate tax is lower than the individual tax rate and it is easier to secure funding and get lower interest loans.
However, it should be noted that the LLC business structure is more complicated. Following regulatory framework can be tricky without counsel, and proper record/book keeping is also very important. Without the proper skills among the founders, it is likely to add extra costs early on to hire employees or consultants to sort through these things.
While LLCs are more expensive and difficult to establish and maintain than a straight partnership, the pros arguably outweigh the cons. The rule of the thumb for choosing a business structure can be simplified this way: the riskier the business venture, the less personal liability you should have.
Trying new things — Innovation, can only happen when you take big risks. By adding a layer between yourself and the business, you allow yourself to be better protected, with the hope that those innovations will pay off.
All things considered, business structures are not necessarily permanent. Startups are often launched in one form but then switched to a different structure later on. As your business needs shift, your business structure will likely be able to shift with it.
