Although Project Nova has captured almost all of the collective attention surrounding our work, the second "new thing" we announced all the way back in January was Kimera Industries - the company that will actually see Project Nova through to production and beyond.
Now, admittedly, this was a bit of a boring announcement to share alongside the computer case we've been working on, but that very much belies its importance. In fact, one of the reasons James and I partnered up was because of my own education and experience in business management, since we knew that a formal business entity would be absolutely necessary if we were to work with metal fabricators, electronics manufacturers, fulfillment centers, and so forth.
Thus, although we (and James in particular) have been on a full-out sprint to finish the design and get feedback from manufacturers, I've been spending a lot of my own time getting the "business-y" stuff for Kimera Industries done. And after some discussions I had with James, I noticed that, when you think of up-and-coming businesses and products, you don't really hear about the late nights and early mornings spent drafting operating agreements and researching tax law. There's all of this legwork that happens to build a company, but few people seem to like talking about it.
So, if you're considering (or are in the midst of) launching your own project, either into a crowdfunding campaign or other venture, I encourage you to read on. For, after considering all of the questions and stumbling blocks that I hit when putting things together for Kimera Industries, I feel compelled to share some of that knowledge and experience - with the intention of helping the similarly ambitious build a company that can support their own ideas and projects.
Hopefully, then, at least some of you will find this particular post to be informative and useful - if not terribly exciting!
Taking Kimera Industries from an idea to an entity
When we first started tackling the challenge of turning ourselves into an actual business, we had a lot of questions about what it really took to do that - and, of course, what sequence of steps were required to get there. Although I was familiar with many of the fundamentals, neither James or myself had any real experience actually creating a company from scratch. And frankly, we (like many in our position) were a bit intimidated by the whole process. We weren't sure where to begin.
Perhaps the biggest questions (or, at least, the most challenging) that we faced, even from the beginning, were:
- Whether or not we needed to form a company at all for our project, or just stick with a general partnership.
- After deciding to create a company, choosing between becoming a S Corporation, C Corporation, or a LLC.
- Picking which state to form the business.
- Understanding how taxes work at the state and federal level.
- Understanding, and knowing what to put in the Articles of Organization/Incorporation, and the Operating Agreement/Bylaws.
- Figuring out the exact step-by-step, from start to finish, to get everything done.
Fortunately for us, however, I had a lot of resources: from information and help provided by my school, to industry connections, and even professors who generously provided business and legal advice. Consequently, for this blog post, I'll be spending a little bit of time on each of these steps, explaining what I discovered through my own research, and what we ultimately decided to do.
Just note that this will all be specific to the United States, and remember: none of what I'm sharing should be considered as legal or professional advice, nor do we assume any liability if you use anything we publish. I'm sharing what I know as (hopefully interesting) service to the community, but you'll still want to do your own research, and consult a professional when putting things together!
Got it? Alright, let's go through each of these questions one-by-one.
"Should we form as a legal company for our project?"
Although I was strongly inclined to believe that forming a company would be prudent (if not absolutely necessary), I withheld judgement on the decision until I had the research to back it up. After all, individuals and partners can simply start doing things, and begin selling products to the marketplace, without any paperwork and other seemingly-undue messiness. If the legal ramifications weren't that severe, that could very well be the best option for two guys who want to do a very small run of computer cases.
However, the consensus of both the literature, and of people in the know, was overwhelming: We'd be crazy not to form as a corporation or LLC for our project. Simply put, since we were looking to bring an idea into reality with a manufacturer, and offer it for sale to others, it was absolutely a good idea to form a "real" business that would recognized by the state.
The (very simple) reasons for this were twofold:
- For starters, corporations and LLCs (the primary entities you can become) provide liability protection in case you are sued, or other unfortunate events happen. An individual selling a product, for example, could be sued for an issue relating to their work or product, only to have their personal assets seized if the lawsuit is successful! Comparatively, with a LLC or corporation, you are personally shielded from any such liability so long as you managed the business appropriately. Only the businesses's assets are at risk.
- The other big reason to incorporate/form pertains to working with other companies and manufacturers. Approaching a metal fabricator as an individual wasn't going to look nearly as professional as approaching on behalf of a company, no matter how artificial that distinction may seem. Plus, the expectation on the part of many manufacturing companies is that they'll be dealing with businesses anyway, since all they do day-to-day are B2B transactions - to the point where you could very well be turned away if you arrive at their doorstep as "Joe" rather than "Joe Case Designs".
If that wasn't enough reason, the fairly low costs associated with forming a company (relatively speaking) made it an easy decision. In most states, the cost to form is between $50-150, and renewals are similarly inexpensive at around $100-150 a year. For liability protection alone, then, forming a company was clearly the way to go.
"Should we become an S corporation, C corporation, or LLC?"
Knowing that we needed to become some sort of entity, our next decision was to determine whether or not we had to come into being as a corporation, or an LLC. Unlike the previous decision, however, this one wasn't as straightforward, and depended highly on our specific circumstances. (To the uninitiated, C corps, S corps and LLCs are essentially different types of companies, that operate in varying ways, but all have basic legal recognition and various liability protections for owners/members, as mentioned earlier.)
For us, at the time that we were faced with this choice, we needed a way to easily compare the differences between the options. So, after some reading, I constructed a table that covered the basics:
- Has many requirements and significant overhead - must elect a board of directors, hold annual meetings, and fulfill annual report filing requirements.
- Is taxed at the corporate level, with dividends (profits returned to shareholders) being taxed at the individual level (leading to double taxation).
- Shares/ownership of the company is easily transferred or sold - this is a particular strength of corporations, and C corporations in particular.
- Relatively complex to operate- you'll want a lawyer and accountant.
- Has many requirements and significant overhead - must elect a board of directors, hold annual meetings, and fulfill annual report filing requirements.
- Income is passed through to the shareholders, so there is no corporate tax - only individual taxes. Further, "reasonable salaries" can be employed to reduce some taxes further.
- Shares/ownership of the company can be easily transferred or sold, but must meet certain IRS regulations, making it a bit less convenient than a C corporation.
- Relatively complex to operate- you'll want a lawyer and accountant.
Limited Liability Company
- Has few requirements and low overhead - no board of directors, no mandatory meetings, minimal filing requirements.
- Income is passed through to the shareholders, so there is no corporate tax - only individual taxes.
- For the most part, shares/ownership are not easily transferred, and aren't conducive to external investment. Many investors will not want to invest in an LLC.
- The easiest of all to operate - you'll want input from a lawyer or accountant at times, but can operate everything yourself.
Although there are many other differences, these were the ones that mattered the most given the size of our operation. And, faced with this information, we eventually understood that an LLC made the most sense for us, as it is the simplest of the three to maintain. Plus, since any income or loss is passed through to us as partners, we only have to worry about taxes at the individual level - a boon not only to keeping accounting simple, but also to keeping the costs of running things as low as possible (an important factor when trying to keep the pricing of a low-volume product down).
Still, even knowing that all at the time, arriving at the right choice of entity type came down to considering many factors - from expected volumes (higher-income companies generally prefer S or C corps), to reporting requirements (which are more rigorous for corporations). And although for us, an LLC made the most sense (given the low-overhead and tax advantages), minor differences in our particular scenario could have changed that rationale. If we expected a lot of sales, and wanted to go public, for example, a C Corp would have made more sense. And if we wanted to solicit some outside investors, but maintain the pass-through taxation benefits of an LLC, an S Corp would have been the answer.
It was at this point in particular that I was leveraging the heck out of online search, and of all the websites I found, perhaps the best free online resource I stumbled upon was Nolo's excellent entity comparison page, which dives into specific examples that better illustrate the benefits and costs associated with each business type. I'd highly recommend taking a look, and going through Nolo's various free resources, if you're still hung up on this, or want a slightly deeper understanding of the differences.
"In which state should we form the business?"
Another question, that actually seemed all but impossible to answer (online, at least), was which state we should form our LLC in. On the one hand, the obvious way to go was to pick a state that either James or I resided in. Yet, there were more than a few articles that claimed how states with no sales tax (such as New Hampshire) were the best choice. More still had people adamantly arguing that you should form in specific states that are "business friendly" - like Nevada or Delaware - no matter where you're located.
As we would later corroborate with our own research, though, the decision is thankfully more straightforward for small businesses: In the majority of circumstances, you really should just form where you're located. For smaller ventures, the difference between states in terms of the base operating cost will only be the filing and other fees, which usually add up to just a few hundred bucks. Yet, if you form in a state you're not located in, you have to deal with everything from getting a remote address, to hiring a professional Registered Agent, to the possibility of a foreign filing in your state of residence, to all sorts of other headaches. And if and when you have to deal with a state government at a distance, it will be cumbersome and take considerable time. Bleh! Not worth it.
Granted, there are indeed some instances where you'll want to consider other states. With James and I, for example, we had the pick of two states to form in, since we live in different areas of the country. That let us pick the better of the two, with respect to taxes (state and sales) and other concerns. Further, even if we were both based in the same state, certain ones (and especially California) can positively gouge you with filing fees, franchise taxes, mandatory permits, and other costs - to the point where it can actually be preferential to form in a different state altogether (Nevada in that case).
Finally, if you're looking to make a company that will either start big, or aims to grow to a considerable size pretty quickly, then (and only then!) will it be expedient to go straight to "business friendly" states (and almost always as a corporation). Since at that point you already have high operating/legal/accounting costs, the particular business-friendly features, and the preferential treatment of businesses and defendants in the courts, will be much more beneficial in the long term.
But, then again, you probably wouldn't be consulting a blog post if that was your plan, right?
"How do taxes work at the state and federal level?"
The answer we were dreading to hear was "it depends" when we started looking into taxes, but that's pretty much what we were told after consulting a few people in the know, and after diving deep into the tax code of our respective states. It really does depend on the state you're in!
Some states charge taxes, and some charge just fees. Usually, you play a flat number on an annual basis, to stick around as a formal entity, but that number can be as low as $100, and as high as many hundreds - or even a straight percentage of earnings. And, the kind of business you're forming, and what you're selling, all dictate how the state you'e located in will ultimately treat you and/or tax you. And this is all before the federal government comes into play!
Let's break this down, then:
For state-level taxes, the best resource I've found that describes these across all 50 states would be, once again, Nolo's analyses, for both LLCs and corporations. And for corporate tax rates in particular, Tax-Rates.com has the most accessible and complete table comparing corporate income taxes by state.
Also, don't forget about sales taxes! Although you don't collect any sales tax at all in states where you don't have a "nexus" (a place of business, essentially), you will unavoidably have to collect sales taxes in the state you've formed in. Often times, this requires a sales tax permit, so consult your Secretary of State to ensure that you know what's expected of you. And don't forget to pay attention to differences in sales taxes at the county (and sometimes municipal) level!
For federal taxes, what you need to pay depends entirely on what type of entity you decided to make! For LLCs and S Corporations, all taxes are paid at the individual level, since they are pass-through entities. Thus, all partners/owners in either business will record their share of any income or losses on individual income statements to the IRS, as self-employed income.
Note, however, that what's recorded is your proportion of net returns - not what was or wasn't ultimately distributed to you! In other words, if you have 50% ownership in a LLC or S corp that has a net return of $10,000, you must record $5,000 in self-employed income from that business, even if you never took any of those returns out from the business!
For a C corp, comparatively, you pay the federal corporate tax rate for the business, and disperse the remainder as dividends to the shareholders/owners at your discretion - who then pay individual taxes on those.
Finally, it's worth noting that, for all but a sole-proprietor-owned LLC, you'll have to get an EIN from the IRS the moment you form (you can do so with a quick online form). This is just an ID the IRS uses to identify your company for tax purposes, but it is absolutely critical that you get it quickly, since everything from federal taxes to the ability to open bank accounts depends on that ID number!
"What should be included in the Articles of Organization/Incorporation and the Operating Agreement?"
I'm willing to bet that half of everyone that reads that title are wondering "Yeah, what do I put in those?" - while the other half are wondering what the heck Articles of Organization even are. Well, in as succinct a manner as possible:
- Articles of Organization (for LLCs) or Incorporation (corporations) are simply the initial documents you file with a state, to declare that you'd like to become an LLC or corporation! The requirements for what needs to be in these can vary from state to state, but for either you generally have to include: an original company name (within some constraints); the address of the company; the owners/members of the company and their addresses; a Registered Agent for the company (someone always available during business hours to receive papers if the company is served by the government); and a dissolution date (when the company will cease to exist, though this is all but a formality). Furthermore, for Articles of Incorporation, there tend to be requirements for much more information, though this (again) varies a lot. To ensure you include everything that's required, you'll want to check with your Secretary of State for filing requirements. Most states have this information easily accessible online, or by phone.
- An Operating Agreement is a document, unlike the Articles, that never enters the public eye (barring extreme circumstances such as some lawsuits), and is specifically used by LLCs (some corporations use bylaws, which are similar, but not identical). It's essentially a contract, between the members of an LLC, that puts down on paper how the business will run, who has what duties and liabilities, who owns what portion of the business, what initial contributions (if any) members will make to the company, and so forth. As such, it is a critical document, since it serves as the legal basis in which the individuals, and even the firm itself, can lawfully conduct business.
Although Articles of Organization or Incorporation are always required to be submitted to a state in order for an LLC or corporation to exist, states generally do not require that LLCs have Operating Agreements. That said, you should absolutely have one if you're an LLC, since any companies that don't default to implied rules of governance that the state has drafted (which rarely, if ever, have the best interests of everyone in mind). It's much better to control your own destiny when things go awry.
While drafting up these documents, and of all the books I looked through, Limited Liability Companies for Dummies was probably the most complete when it came to the purpose and content of Articles and Operating Agreements. So I'd suggest picking up a copy if you need the help - at $20, it was well worth it.
"What does the step-by-step look like for pulling all of this together?"
Although I should reiterate that the process of forming a company varies considerably state-by-state - and depends on what kind of company you're looking to make - a rough timeline that encompasses everything would look something like this:
- Figure out which kind of entity you'd like to form, and what state you'd like to form in.
- Consult the Secretary of State and figure out everything you need for your Articles of Organization or Incorporation. Also check to see if you will need any permits.
- Check at both the state and federal level to ensure that the name you want to use for your company isn't already trademarked or in use. Your state's website for the Secretary of State, as well as the federal government's USPTO website, will have search portals where you can do this.
- Draft your Articles of Organization and your Operating Agreement. And, at the very least, consult a lawyer or qualified representative to review your documents and ensure that they are up to snuff!
- If you aren't electing to be your own Registered Agent, reach out to an RA company and hire one for you that's based in the state you will be forming in. This usually only costs $99/year or less, and is ideal if you want to hide your name actual home address from the public record (for privacy concerns).
- File your Articles with your state, triple-checking everything for accuracy so you aren't rejected because of a silly mistake. Some states you do this online, but you usually have to mail them in. Alternatively, you can present them in person, which usually expedites things.
- Once the state approves your filing, immediately have all owners or members sign the Operating Agreement, not only at the end, but on every page - as well as next to the sections that declare ownership shares, and initial contributions. At the same time, immediately get your EIN from the IRS if you aren't a single-owner LLC.
- Finally, ensure that all owners and members have copies of all of the aforementioned documents, and entrust someone to hold and manage a binder with copies that will act as the company's book of record. Have all of this recorded, and have redundancies in place in case original copies are lost.
Ever since we've squared all of this away a little while ago, I'm happy to say that Kimera Industries LLC became an official entity fairly recently, after our own Articles of Organization were filed, and our application was certified by the Secretary of State. As we're currently in talks with potential manufacturers, this was an important and welcome milestone, since we can now engage with companies throughout the supply chain with the capacity and professionalism as a full-on business, rather than as individuals.
Still, even with that particular bundle of work behind us, I remain vividly aware of how long it took to do everything - and I recognize how darn lucky we were to have the assistance of a professor and lawyer, who gave us free legal advice, and reviewed our documents. I understand firsthand that, for those who aren't really familiar with this process, the cost of getting everything done (both in time and dollars) is pretty high. And that just rankles me, to think that this burden could prevent really promising community-inspired projects from taking off.
So, beyond talking through our own experience, I've elected to take the actual Articles of Organization and Operating Agreement used by Kimera Industries, and generalize them into templates that are free for anyone to download and use. For although there will always be many differences between projects that demand their own documentation, there's a lot of common ground across businesses, and especially those that look to take products like Project Nova to market at a small scale. So I think that this blog post, and the templates, can at least serve as a really solid starting place for people, saving them time and money, and (hopefully!) making market entry that much more attainable.
(Just note that these will only make sense for LLC's - and, again, that we assume no liability from their use!)
Anyway, I hope this has been informative, or at least interesting, and I'll be looking to post an update in the future that discusses some of the day-to-day challenges surrounding the management of a newly formed business! If you have any questions you'd like to ask until then, however, feel free to contact us here, or join the conversation surrounding Project Nova on SFF Forum!