Legal

I received this very good question from a reader about share ratios when converting from a partnership to a LLC. Note I have dropped his name and changed the details a bit

Let me ask you…I am about to form an LLC for a small business that I have been running for several years. I have one major partner, and I am trying to get some advice on whether I should split the shares 50-50, or if I should retain
a majority (55-45) since I was the founder and ultimately have the largest assets into the business?

Firstly, much more than a legal issue this is a human issue. It really depends all on your relationship with the partner. The simple answer from a legal standpoint would be to retain the majority, because you don’t know what could happen in the future.

All this being rationally true it could work against
you, maybe your partner would feel cheated because of this and start
bearing a grudge. As in any relationship grudges have a way of rearing
their head at some point in the future, when you least want them to do
so.

To sum it all up while rationally you should have more because you are the founder, you need to avoid grudges against you, but then again you also need to avoid grudges in you against your partner. It is all together better to avoid the times when you need that controlling stake, than having a remedy after the fact. Condoms over abortion!

One thing you might try is to offer a 50%/50% revenue split, but retain control. That seems like a good compromise. Stuff like that you can specify in the LLC agreement or in a separate contract.

Also remember I am no lawyer, then again this is a human subject and lawyers only ever should get involved when the human beings are past talking.

Anyway if anyone else has questions, please send them to me at [email protected] and let me know if you want to be anonymous. Of course I am no lawyer and I my answers might cause you to loose your house or worse your powerbook. Also feel free to comment with your own experiences and opinions below.

Just read this cool article Pioneer of the Flat Tax about Mart Laar the first prime minister of an independent Estonia.

It reads almost like the story of a typical hard headed young entrepreneur who doesn’t yet know all the reasons why something can’t be done.

Imagine a place with no tax accountants, where the annual return takes a businessman an hour to complete. Think how you could lead a country and design an economy just as you liked. Consider the joy of creating a tax system with no loopholes and exemptions, where everyone is treated the same.

When he became the prime minister of Estonia at the tender age of 32, Mart Laar saw this opportunity as a beautiful thing. The Soviet regime that once ruled his country had been overthrown, and he was starting with a clean slate – and the confidence that came from reading only one book on economics.

This table shows how it compares to UK Tax.

“Most experts advised against it and said it was a very stupid idea,” he said. “My finance minister said don’t do it, the IMF said don’t do it. But it’s not very easy to convince a young person that he is wrong and I was that type of young person. So I did it.”

This is how Bezos started Amazon. Max and Peter PayPal. Classic hard headed entrepreneurial spirit.

Thanks to Scott at Baltic Blog
for bringing this article to my attention. He says:

As an American with a screwy tax system that confounds me, even that as an ex-pat, doesn’t owe any money but can’t figure out the proper filings forms because of the Byzantine nature of the U.S. tax system, Estonian tax filing is simplicity in itself. It is all Web-based, and generally take 10 minutes to file.

As all of us entrepreneurs know, tax is a pain in the *ss. While obviously paying a huge percentage like we do here in Denmark is bad enough, I think for many smaller entrepreneurs the reporting overhead is actually worse.

Also in places like Denmark you tend to worry more about your deductions than your income. Imagine a 0% tax on your business. What kind of clarity in your daily life would this give you? Focus on your business effect and not the tax effect. I have been considering Estonia for a while as it certainly is an attractive place for a startup.

I have always been interested in security and cryptography and have always been annoyed with the security disclosures or lack of them that most web applications offer.

Therefore I am making StakeItOut’s Security Page
painfully public for the world to see. I think it is better for small fish like me to be honest and not end up in a situation with some huge liability on our head.

BTW. I am writing these kinds of things bit by bit in Backpack as I am putting most of my focus on site functionality at the moment. Backpackit is just great for these kinds of things. The next wave of beta testers should be invited in, within the next day or two.

Choosing a legal structure for your new venture is some thing that you do have to think about. If only for planning purposes. Having gone through the offshore companies is cool phase a long time ago, I decided that there are really two things you need to think about:

• Whats best for your business?
• Whats best for your and your partners personal economy?

Why are these separate. First of all what is good for promoting and growing your business is often transparency and flexibility. What is good for your personal economy is not necessarily that. All kinds of tax rules make the varying structures good for various kinds of people and incomes.

Whats best for your business?

First of all without your business doing well you wont have any personal income to worry about, so this should come first.

For this transparency, flexibility and simplicity is vital. When you are just in the early bootstrapping phase like I am right now, you dont want to be bogged down by bureaucracy or extra costs.

On your own

When you are just starting out and you are only in business with your self, you are already as transparent as can be. So theres not much to worry about.

Partnerships

If you are working on this with one or more partners you need to keep things simple and transparent, no matter how good friends you are. This also has the added benefit of keeping out the lawyers and letting you yourselves decide whats best.

Transparent and short partnership agreement

Following rule 2 from my 6 simple rules for micro ventures distribute revenue early and often. This requires that each partner knows what his job is and what his share of income is.

Lets say Bob takes care of hosting and programming and his partner Mary takes care of marketing and sales.

They should according to my rules say that Bob takes care of the entire hosting and development task all costs included. In return he receives %70 of income.

Mary on the other hand has agreed to take care of the entire sales and marketing task including all costs in return for %30.

This is very simple and keeps the inevitable arguments under control.

They can always renegotiate this in the future or bring further partners in if need be.

In most partnerships you have the inevitable arguments about money, expenses, investments etc. This way you can split this out entirely.

All of this points to the best structure for your business at least in the startup phase is a partnership or variation there of.

Most countries allow you to setup partnerships just by entering an agreement between yourselves. While you are in the idea phase a verbal agreement should be fine. However it might be a good idea to write it down in clear language what each of your tasks and responsabilities are on what share you receive for this.

Once you start actually doing business above the hobby level, you probably may need to do some kind of formal registration of your partnership. Some places like Denmark it is actually beneficial to register for VAT purposes immediately, so your purchases are vat free.

Limited Liability Company

For international use (but read what I say below), say Bob is in Australia and Mary is in Norway a US Limited Liability Company (LLC) is almost certainly the way to go. Bear in mind though that this does cost a few hundred bucks to set up if all of your partners are abroad. If one or more of the partners are resident in the US it can be done cheaply and easily by yourselves. See this book for the best how to I know of:

LLC’s are great. They are transparent for tax purposes like a partnership and offers the warm comfy feeling of limited liability. They also do setup a more corporate image if you are into that sorts of thing, just remember be a business dont play a business.

I should also say that you almost certainly dont want to create your LLC until you have some income. It is a cost and there is bureaucracy involved. That is also why its good to move to a LLC from a partnership, because for tax purposes they are exactly the same, so no hassle.

If you are outside the US or just want someone else to manage it you can use a corporate services provider like this one (Disclaimer while they look sound and I am considering using them myselves, I do not have first hand experience with them):

Why not corporations?

Corporations where designed with something called the corporate veil, which essentially means its a black box. It acts and is taxed like a seperate person and has tons of rules behind it which cloud and never enhance the transparency.

This is good for dealing with investors. Venture Capitalists will amost certainly want you to be a corporation if you wanted to do the non-bootstrap route. As a bootstrapper though stay away for your business.

Remember though that you and your partners personal tax planning is an entirely different thing and each of you might find a use for them there.

Single person LLCs

As I said before, create your LLC when you have the money and time to spare to do so. While they are partnerships strictly speaking you may still incorporate them with you as the only partner in many US states.

Now why would you want to do such a thing? Well this would make it easier for you to bring further partners in later.

Google/Yahoo/IBM have offered to buy us, what next?

First of all congratulations. As you are now out of the bootstrapping phase you should convert the LLC into a real corporation at the exact share percentages as before. You should also by now have money to pay a lawyer to do this for you well.

Whats best for your and your partners personal economy?

Everyone is different and have different needs and requirements. If you are in the startup phase and are Funding through a nine to five like I am. I want to deduct all my costs and expenses against my salary. You may not be able to do this in your country, but in Denmark and the US you can. So that is my requirement.

Later on when my business starts making money, my requirements will most properly change. I will probably want to leave income in a company to reinvest later. I might even move to a place with a better tax climate than here. This should be my choice and not my business partners.

I therefore recommend that you startup just having everything as personal income/costs (US 1099). Then when you start breaking even create a personal holding company, which is just a corporation that you yourself own. This does not even have to be in your own country of residence, but do check local rules and regulations about this.

Conclusion

As my old Danish teacher always tought me in grade school, “you always need a conclusion Pelle!”.

Basically keep your business simple and transparent using partnerships or just as a self employed.

Your personal financial and tax strategy should be kept separate from your business.

And as always IANAL
this is just based on my own experiences and often alcohol controlled thought patterns.