Off on the Right Foot

In one of my funner activities, I offer my two cents of advice to start-ups coming out of MIT as a volunteer mentor in its Venture Mentoring Service.  For ventures just getting started, a common topic of discussion is what legal identity the venture will adopt.  This is an important step since it indicates the seriousness of the founder(s) and her/his/their commitment to the enterprise, establishes credibility, and is a signal of how the business will operate.  Most founding teams will opt for one of the traditional forms for a corporation (see below), but occasionally a team will be interested in forming a non-profit organization.  The reasons are usually because it equates the non-profit label with a mission to do social good and/or intends to fund the company with personal gifts or grants from foundations which typically have policies of giving money only to non-profits.  In response, I point out that a for-profit can have a social mission (it just puts it some or all of its revenues above expenses back into its mission as opposed distributing it to shareholders) and that an organization’s incorporation should reflect the best way to accomplish its mission as opposed to how it expects to be funded.  I also point out that most start-ups operate without profits and sometimes revenue for several years (or longer if the venture is developing a technology-based product), so practically, the for-profit/non-profit dichotomy is a false one.  I also note that nonprofits tend not to have a clear understanding of whom they intend to help or how and often make the grantors their customers, neither of which lead to a viable enterprise.

While I’m clearly not an expert in incorporation, I thought it would be worthwhile to write on what I did know and posit what mode a venture that is developing products for global health may consider.

Starting with nonprofits, a nonprofit is usually required to register as charity at the state level, can solicit donations and grants, and avoid paying taxes by receiving a 501(c) designation from the Internal Revenue Service.  The application process costs several thousands of dollars in fees and legal assistance and takes several years or longer, since the IRS has a large back load and unclear criteria for eligibility that it applies unevenly.  Again, I think there are alternative sources of start-up funding other than gifts and, to many people, nonprofit is equated with non-revenue which makes long term viability problematic.

A for-profit is registered at the state level in the states in which it does business (for most start-ups this is the state where the founders live).  It can raise pre-revenue funds through friends/family, foundations (rarely), governmental grants, and investors who expect (hope) to get their money plus a profit back at some time; however, most start-ups are a long way from being attractive to investors.  For-profit companies typically incorporate as either “C” or “S” corporations, although there other structures such as partnerships, used for short-term business efforts, and limited liability companies (LLCs), used for service businesses.  The latter have various tax and liability advantages that are too deep for me but I found useful explanations and comparisons at Incorporate.com.  Incorporation is done with a home state government or in Delaware due to its business-friendly courts by filing an incorporation document and by-laws and paying a fee.

As I understand it, the C (or general) corporation has the advantages of limiting the liability for directors, officers, shareholders, and employees and the ability to sell stock with no limit on the number of shareholders, although it is required to register with the SEC when it reaches $10 million in assets or 500 shareholders.  The profits of a C corp are taxed as corporate income and as dividend income of its shareholders.  An S corp is a C corp that has elected with the IRS to have its profits and losses “passed through” to the owners/shareholders apportioned by ownership, theoretically reducing the total tax paid.  Also, the owners/shareholders report the profits and losses on their personal income taxes, simplifying the company’s paperwork.  S Corporations have a number of restrictions, e.g., it may be owned only U.S. citizens or permanent residents, may not have more than 100 shareholders, and can issue only one form of stock.  This last point makes the structure unappealing for companies seeking venture capital since early investors want “preferred” stock with its benefits.  So for a global health start-up, incorporation as a C corporation makes sense.

In a previous post, “More Fun and Profit”,” I noted a new structure, the “B” or benefit corporation, that is available in six states including California and New York.  This structure allows the company to make decisions needed to meet a social mission, like improving he environment or global health, rather than on profit maximization for shareholders.  A B corp has the structure and requirements of a C/S corporation, but assures that the owners, managers, and shareholders accept the primacy of the mission over profits.  For a discussion of the B corp for life sciences companies, see a recent Bioworld article, and for a whole lot more on the B-corp movement see B Lab.

This is obviously a very broad-brush summary of incorporation options, but it seems to me that the C corp, with the B modification, if available, is the route for global health start-ups.  But I’m happy to be enlightened by those with more experience.

 

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