The business structure of any startup is naturally going to determine a lot about how it operates.
From determining a startup’s tax rates to dictating its methods of acquiring funding, to establishing the way it appears in the eyes of the public, its customers, and its competition, choosing the most effective business structure for a startup is a critical first step.
But given the many different business models out there, and the multiple benefits and downsides found between them, picking the one that’s best suited to any single startup is easier said than done. To proceed with any confidence, each of the following options should be considered and compared with the goals a startup has in mind—and the people who comprise it.
1. Sole Proprietorship
This business structure is the simplest of the five, and results in a combination of an individual and their enterprise.
Commonly employed by freelance workers and independent contractors, sole proprietorship merges one’s business assets and personal finances together. Any operation that doesn’t officially register itself to a business model is also automatically recognized as a sole proprietorship.
Some benefits of this structure include the fact that it’s easy to establish, and yearly taxes are relatively simple. Since the business and founder are considered a single unit by the U.S. government, both entities’ taxes get filed together. At the same time, however, sole proprietorships have to pay additional self-employment taxes that go into social security and Medicare.
But for a hardware startup, a sole proprietorship is rarely going to be an effective long-term business model.
Unless one is in its very first stages and still validating its product or service, it shouldn’t run the risk of proceeding without the limited liability protection other business models provide. Otherwise, a startup’s founder will find themselves gambling on their company’s success with their own personal assets. If something goes wrong financially, they could end up paying for those troubles with their car, or even their home.
A partnership is like a sole proprietorship in a variety of ways, though it has multiple founders rather than one. Oftentimes you’ll see this business structure applied for certain professional groups, like attorney offices.
Again, this is an easier business structure to establish with low costs, but all risk falls back on the founders. Because of the financial risks, partnerships aren’t recommended for hardware startups beyond the point of product validation. However, there are still some key differences to note, like utilizing the combined capital of multiple founders, enjoying greater borrowing capacities, and the option to bring in more partners to grow the organization. Though that also means that partners can leave, and when they do the startup will likely diminish in value.
It’s also important to remember how critical a fluid relationship between partners is here. While like-minds may work great together, rifting personalities and perspectives can cause a partnership-based business to crumble.
3. C Corporation
One of the more common business structures, when people talk about corporations, C corporations are the model they’re usually referring to. Companies that plan on selling stock for their fundraising efforts will want to consider this option. The same goes for founders who anticipate leaving their company at some point.
They provide the greatest liability protection of all five mentioned business structures, as they aren’t owned by their founders. Instead, C corporations are owned by outside investors and shareholders who are brought in through crowdsourcing and other marketing methods.
However, C corporations do have their downsides, such as the possibility of experiencing double taxation from the same sources of income. Furthermore, unlike other models, C corporation startups can’t write off their losses through personal taxes. As most hardware startups tend to see low monetary returns in their first years, this can be a costly factor.
Lastly, C corporations experience more complicated tax filing processes, with corporate forms lending to lengthier documentation. Because of these added complexities (and the presence of legal loopholes corporations can use to bring down their tax liabilities), it's recommended that startups who choose a C corporation business structure hire a professional attorney for assistance.
4. S Corporation
Unlike partnerships and sole proprietorships, an S corporation enjoys limited liability protection and passes its profits and losses onto shareholders for federal tax purposes.
That’s because under this business structure, shareholders report the income and losses of S corporations they’re involved with onto their personal tax returns, and are assigned taxes according to their individual income tax rates.
This means, while dealing with a similarly complicated tax process, S-corps get to avoid the instances of double taxation that C corporations experience. Though, depending on the state that an S corporation is based in, there may be limitations on the amount of profits and losses a startup can pass onto their shareholder’s tax returns.
Additionally, S corporations in the U.S. are limited to 100 shareholders, and each one must be registered as a citizen. Depending on the number of shareholders a startup aims to have, this may be a key deterring factor.
5. Limited Liability Company
A limited liability company (LLC) is a viable structure for most any type of business, and great for hardware startups.
In practice, an LLC essentially takes elements from corporations and sole proprietorships and melds them together.
For instance, LLC startup profits and losses are passed onto the founder’s personal income, and self-employment taxes must be paid. But at the same time, LLCs get limited liability, which protects the personal assets of those involved. LLCs are also inexpensive to start, and without strict documentation requirements, they’re easier to maintain than S and C corporations.
Really, the main limitation that comes with running an LLC is only the inability to sell company stock to investors to raise outside equity-based funding when desired. To do that, an LLC would need to set up a corporation first.
Nathan is a California-based writer who hides from the sun to write and market web content in all of its forms. He enjoys writing about most everything except for himself—especially when it’s in the third person.