Thread by @KHendersonCo

Alright, #SMBTwit asks and it receives!

So, lets break down entities and how to smartly create and form your HoldCo entity structure.

Grab a mimosa, and let's dig in! 🧵

https://twitter.com/blind_nut/status/1621480004054880257

Step 1: Determine if there will be more than one party (e.g. partners or third party investors) at any level of the structure.

If yes, stop. Hire a lawyer. More on this below.

If no, go to step 2. (1/x)

Step 2: If all entities will be wholly-owned (e.g. only one person or entity will own each subsidiary), determine entity form (C Corp or LLC, generally).

If C Corp, stop. Hire a lawyer. More on this below.

If no, go to step 3. (2/x)

Step 3: If you're forming an LLC, determine if you're going to make a S Corp election.

If yes, hire an accountant to be sure that you understand the implications for the timing of the election.

Then go to step 4. (3/x)

Step 4: Form your LLC. You can use a lawyer if you want to, but honestly for a wholly-owned LLC it's not the end of the world if you want to use a service.

But you probably don't want to DIY this so that you can be sure you observe proper formalities. (4/x)

There's a concept called "piercing the corporate veil" whereby someone suing your LLC and can "pierce" the limited liability nature of the entity and recover directly from the member if certain formalities aren't observed.

So you want to set your entity up properly. (5/x)

That means passing proper authorizing resolutions upon organizing your entity and adopting a written Operating Agreement.

If you just go search google and pull a random form, you run the risk of getting key items wrong, even in a wholly owned LLC. (6/x)

I've seen operating agreements provide for partnership tax treatment (not allowed for a single member LLC) or for management by managers when entity is formed as a "member-managed".

You should have an operating agreement and it can be simple, but it should also be correct! (7/x)

So let's circle back to step 1.

Why stop and hire a lawyer if there's more than one party involved?

A few reasons:

1️⃣ Complicated governance
2️⃣ Compliance for equity investments
3️⃣ Stakes go up considerably

(8/x)

1️⃣ Complicated governance

At a minimum, if you have partners (even if you don't have third party investors), the governance is complicated.

Once you add investors, the governance gets even more complicated.

(9/x)

A few governance considerations when drafting governing documents:

▶️ Timing and method for capital contributions
▶️ Timing and amount of distributions/dividends
▶️ Management rights
▶️ Protective rights
▶️ Buy/Sell agreements
▶️ How to handle deadlocks

cont... (10/x)

▶️ Transfer restrictions
▶️ Equity structure (class and rights)
▶️ Corporate opportunities
▶️ Reporting requirements

Just to name a few!

A good, comprehensive operating/shareholder agreement will be long and complicated, Well worth the cost to get it right. (11/x)

2️⃣ Compliance for equity investments

Taking investments from 3rd parties requires more than just taking money and adding them to the cap table.

Anytime you sell equity to a third party, it has to either be registered with the SEC (an IPO) or exempt from registration. (12/x)

General in SMBs, the sales are exempt under Rule 506 of the Securities Act.

Securities laws are complicated and the risk of getting it wrong can be massive...rescinding the investment and effectively bankrupting your company. (13/x)

Most lawyers aren't securities lawyers. It's a unique and complicated area of the law.

That means many solo and small firms don't have malpractice insurance for this area of law. (14/x)

Do your due diligence to make sure you hire someone that knows what they're doing and has insurance so that you are protected!

For more on Rule 506, see this response thread from my partner @SMB_Attorney. (14/x)

https://twitter.com/1429641923627651072/status/1602489027080474626

3️⃣ Stakes go up considerably

Simply put, with partners/investors, litigation risk goes up exponentially. You face litigation risk not only from third parties but also investors and partners.

But if your entity is wholly-owned, you're unlikely to sue yourself... (15/x)

Next, lets revisit Step 2.

Why hire a lawyer for a C Corp, even if it's wholly-owned?

LLC's are largely contractual entities outside of the basic formation.

Corporations, OTOH, are largely governed by statute that can be overridden by certain contractual arrangements. (16/x)

Remember that whole "piercing the corporate veil" we referred to earlier?

Lack of proper corporate formalities is one of the primary ways for a plaintiff to successfully win that argument. (17/x)

Because corporations are governed mostly by statute and not contract (like LLC's), setting up the bylaws and shareholder agreements correctly is imperative to maintain limited liability.

You'd be shocked at how many DIY single shareholder corps I see with no bylaws... (18/x)

So where does that leave us?

Even if I don't recommend it, a single-member LLC can pretty effectively be done DIY, or using a cost-effective filing service like Legalzoom.

Most other cases benefit significantly from competent legal counsel. (19/x)

Finally, I'll leave you with this thought.

If you're reading this tweet, you're likely shopping for a business for which you're going to pay somewhere between $1M and $10M for.

With that in mind, ask yourself this: (20/x)

Is messing around with legal compliance and entity formation the best use of time to save $500 or $1,000?

It feels like a lot, but the cost of getting this wrong is orders of magnitude more than that.

I suspect your time is better served searching and finding a business. (/end)

That's a wrap!

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