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Wasserman’s research also clarifies that a discount exists for founder compensation. Another interesting posts talks about splitting the pie, how the founding team splits equity.

Rich vs. King posts

• Rich vs. King – Core Concept
• Rich vs. King – Charts and Impressions

The Idea person

• Idea person’s initial role
• Second look at Idea person’s initial role, should vs. do.
• Idea premium, how much equity is it worth?

Other External Links

• Ask the VC, post 1 and post 2 and post 3
• Altgate referencing Noam Wasserman’s survey as well as Advanced HR

An LLC is the more flexible of the two types of entity discussed in this article (LLC and S-Corp).  In essence, you can have any tax treatment you want.  A couple of examples:

• All tax write-offs (during periods of losses) to someone who hasn’t contributed capital, or to someone who has only provided a limited % of the total capital raised.  Compare this to an S-Corp where everything is based off the individual’s tax basis (discussed below in S-Corp section).  Angel investors sometimes find this flexibility attractive.
• Can behave as a pass-through tax entity, or not.  This is determined by an election.  By comparison, an S-Corp is a pass-through tax entity, and a C-Corp is not (meaning that owners of C-Corps are double taxed).

Another interesting difference between LLCs and S-Corps is the treatment of owners with respect to tax withholding.  If an individual owns more than 2% of the LLC, the IRS considers them a partner that will receive a “guaranteed payment”.  Because of this, withholding taxes are not performed for the owners of greater than 2% of an LLC (each owner must pay the IRS quarterly).  Each owner must instead file a K1 and pay taxes quarterly.

S-Corporations

Some notes about S-Corporations and their limitations:

• Up to 75 shareholders, who must be U.S. individuals or trust funds; cannot be an entity (e.g. LLC or Corp), or foreigners.
• Only one class of stock, although can have differences in voting.

For S-Corps owners, withholding taxes are paid the same for owners as employees.

The examples below are focused on S-Corporations.  Notes regarding LLCs are summarized at the end of each example.

IF OPERATING PROFITABLY

Revenue            $200,000

Owner 1 Wage     $25,000  W2 Form (Owns 75% of company)

Owner 2 Wage     $50,000  W2 Form (Owns 25% of company)

Other Expenses   $25,000

———————-

Net Income (K1)  $100,000

Owner 1 Net Income $75,000   K1 Form

Owner 2 Net Income $25,000   K1 Form

For an Net Income with an S-Corp social security and medicare is not required (saving 15.3% in taxes to each owner).  This is the reason that the IRS flags S-Corps where owners do not have a salary component to their compensation.

For LLCs, the 15.3% employment taxes is still typically paid on the Net Income.

Tax basis for this example:

Owner 1          $75 + $75,000 = $75,075

Owner 2          $25 + $25,000 = $25,025

IF OPERATING AT A LOSS

Revenue              $50,000

Owner 1 Wage     $25,000  W2 Form (Owns 75% of company)

Owner 2 Wage     $50,000  W2 Form (Owns 25% of company)

Other Expenses   $75,000

———————-

Net Income (K1)  ($100,000)

Tax basis determine amount (up to pro-rata of loss, assuming no investors)

Tax basis Owner 1   $50,075  (50k investment, and 75 for buying shares)

Tax basis Owner 2   $25      (25 for buying shares)

Therefore, Owner 1 can only deduct loss of $50,075 of the ($75,000) pro-rata loss amount.  Owner 2 can only deduct $25 of their pro-rata loss amount of ($25,000)

For an LLC, owners can get tax basis for outside loans especially if loans are secured by guarantee or real-estate.

The implications for using a good law firm are:

• The formation will be done with the big picture in mind (raise money, get acquired or IPO).
• Investors will see your legal representation as a “check-box” and a soft recommendation of your potential.
• Potential deal breakers will be avoided, such as not having Intellectual Property properly assigned to the company.

So, how do you find the best law firms in your area?  Our suggestion is to find the local entrepreneurial not-for-profit entity.  This local entity/organization is usually state sponsored, but varies from region to region.  This organization will most likely host networking events.  The sponsors of these events will be the local service providers, including law firms, that are reaching out to the entrepreneurs.  Therefore the first step is to find these sponsors, do some homework on the firms, and meet with them.

Each firm will have its own strengths/weaknesses.  The key is to ask around within the entrepreneurial community and find out:

1. The firm’s reputation with entrepreneurs (if possible, the reputation with investors is equally, if not more, important).
2. The accessibility of the representative that you’ll be working with (hopefully a partner, but it depends on the size of the firm).
3. What terms they offer.  This is key, as some firms will allow deferrals of the payments until the first financing event.  This varies greatly on your geographic location, so do your homework to make sure the terms are competitive.