Forming the company and structure

Taffy Williams

Colonial Technology Development Co.

You are planning to start a new biotech or pharmaceutical company. Which comes first, the company or the technology?

It is a bit like the chicken and egg story: it really does not matter. You can create the company and fill it with technology, even years later. You can find technology and create the company overnight (or in a few days). Either option works.

The more important issue to resolve is the type of business structure you want, a Corporation, a Limited Liability Company, or some other structure. A few structures are defined below via the site www.investorwords.com:

• Corporation

“The most common form of business organization, and one which is chartered by a state and given many legal rights as an entity separate from its owners.

“This form of business is characterized by the limited liability of its owners, the issuance of shares of easily transferable stock, and existence as a going concern. The process of becoming a corporation, call incorporation, gives the company separate legal standing from its owners and protects those owners from being personally liable in the event that the company is sued (a condition known as limited liability).

“Incorporation also provides companies with a more flexible way to manage their ownership structure. In addition, there are different tax implications for corporations, although these can be both advantageous and disadvantageous.

“In these respects, corporations differ from sole proprietorships and limited partnerships.”

• Limited Liability Company (often abbreviated to LLC)

“A type of company, authorized only in certain US states, whose owners and managers receive the limited liability and (usually) tax benefits of an S Corporation without having to conform to the S corporation restrictions.”

“It is not recommended that you manage all of the tax filings yourself.”

Clearly, there are several structural forms available for your business. The best way to select the right one is to review the options and discuss them with your legal representative and/or accountant.

The choices between LLC and Corporation have a lot to do with taxes, payout of cash, and ownership. There are pluses and minuses for each. Weigh the differences and identify which structure best fits your company’s future needs.

Many biotechnology, pharmaceutical and medical companies eventually become C Corporations. As defined in Wikipedia:

• C corporations are corporations in the US that, for federal income tax purposes, are taxed under 26 U.S.C. § 11 and Subchapter C (26 U.S.C. § 301 et seq.) of Chapter 1 of the Internal Revenue Code. Most major companies (and many smaller companies) are treated as C corporations for federal income tax purposes.

• The income of a C corporation is double taxed, whereas the income of an S corporation (with a few exceptions) is not taxed at the entity. The income, or loss, is applied, pro rata, to each shareholder and appears on their tax return as Schedule E income/loss.

• Unlike corporations treated as S corporations, a corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.

“If you thought you would not have a boss, guess again!”

The C Corporation is one of the structures desired by the funding sponsors considering a future IPO (initial public offering). It is registered with a state (Delaware for example) by filing the appropriate documents and paying the filing fee. You can work with an attorney to file the forms and your counsel will generate all the paperwork associated with the company creation. It is possible to go through the process without legal assistance, but not recommended.

There will be associated costs of as little as a few hundred dollars to more than a thousand for creating the legal entity. It depends on the complexity and the legal billing rate. Ask what this rate is before you start, and get an estimated total cost. Don’t suffer ‘sticker shock’ after the job is done! Most of the structural issues can be changed later by your legal representation at a modest cost.

On forming the legal entity of your business, you will need to obtain a tax ID code from the Internal Revenue Service (IRS) if you are in the US. Look into other tax authorities if you are outside of the country.

A corporation is like having a separate person to account for with respect to the state and federal government. The corporation will have regular tax and reporting obligations even if it has no source of revenues. In the US, you will need to request an EIN number from the IRS, this is like a social security number for a company. The EIN is to be your tax ID for all future filings. Your legal or financial adviser can help obtain the EIN and help with all future filings.

It is not recommended that you manage all of the tax filings yourself. You are likely to get notes from the state or IRS telling you that you have missed dates, that the estimated tax or the tax paid is not correct, or other not-so-pleasant notes.

When you form a corporation or an LLC, you will have ownership that will be represented by issuances of shares. These shares reflect your fractional ownership of the business. For example, if you and your partner own half of the issued shares each, you each own half of the company. The control of the company is 50:50 as well, as is the voting of the shares, unless you have created a structure defining different classes of shares with different voting rights.

Keep in mind that when you have critical decisions, they are often put to a vote by the shareholders. A 50:50 ownership could result in ties unless you have other arrangements in advance to break such ties. How you structure the control of the company and divide the shares will be an important consideration. Most of the structural issues can be changed later by your legal representation – at a cost.

“Suffice it to say, it is better to have 10% of a lot of money than 100% of nothing.”

Following the formation of the company, a board of directors needs to be selected. Yes, you will need one. If you thought you would not have a boss, guess again! Almost everyone has a boss of some type.

The board of directors has the responsibility of oversight of the company with oversight and direction of the senior management too. This is often done by review of activities and setting milestones for management to achieve.

The board reviews the finances and ensures accuracy in reporting and spending. Its directors have a legal responsibility to ALL investors to ensure proper and ethical management of the company. They will be your boss.

The members of the board of directors are elected by the shareholders. On the first day of formation of the company you may be the only shareholder and own 100% of all issued shares. But as investments are made and shares are issued to new investors, your percentage ownership will be reduced.

Don’t be surprised if your 100% ownership eventually drops to 10% or less as you get funds from selling shares. This means the board will have a stronger representation from the investor pool, and that your boss will have stronger connections to the new shareholders than to you.

Please do not get hung up on dilution. Suffice it to say, it is better to have 10% of a lot of money than 100% of nothing.

Read Taffy’s previous article, Patent filings and maintenance cost money.

About the author:

You can follow Taffy Williams on Twitter @twilli2861

Email questions to Taffy: twilli2861@aol.com or use his company or photo websites.

You can also find him in the Startups Group on Linkedin.

Other articles can be found in the Charlotte, NC- small business section of Examiner.com.

Which comes first – the technology or the company?