How to Select the Right Business Formation

So many business owners ask me to verify if their business is set up the “right” way. The short answer is that the key to a good business formation is to make sure that the formation works with the dreams you have for your company. 

Let’s use Facebook as an example. Mark Zuckerberg had a dream while in his Harvard University dorm room in 2004. But before he could bring his innovation to the masses, he needed to choose a business formation that would work with his vision. No one could have predicted, what Facebook would ultimately become. And yet, at the beginning stages of any company, every business owner must these important decisions without knowing what the future holds.

Prior to defining Facebook legally, it was just a fun project among Mark Zuckerberg and his friends.  According to the records, Mark Zuckerberg first formed a limited liability company, or LLC, based in Florida. The legal formation LLC is considered a “hybrid” business form because it allows the company to be treated as either a sole proprietorship or partnership for tax purposes, while providing the legal protection of a corporation to the investors.   

The drawback of an LLC is the complexity of taking on additional investors. An LLC is treated as a sole proprietorship unless elected to be treated as a partnership. In the case of Facebook, each individual investor would be considered a “member” and would be taxed on the earnings of Facebook.  It isn’t surprising that a year later the legal formation was amended to create the Facebook Corporation. 

As a corporation, Facebook became its own legal entity, and accepting additional investors was much easier now that the company could exchange this additional investment for shares of stock. In the summer of 2004, the company received its first angel investor: venture capitalist Peter Thiel made a $500,000 investment for 10.2 percent of the company’s stock. 

As with many tech companies, outside investment was needed in this early stage to help the company continue funding its operations until it turned a profit for the first time in 2009. 

In 2012, Facebook became publicly traded, which required the company to file with the Securities and Exchange Commission for the first time and allowed the shares of stock to be listed on the public exchanges. By launching an initial public offering, Facebook shares could now be purchased on a public exchange and actively traded among investors.  To make sure that early investors retained control over decision making within the corporation, Mark Zuckerberg maintained a 22 percent stake in the company stock. 

Facebook is a great example of the importance of finding a business structure that fits your company’s future. As an LLC, Facebook would not have been able to take on additional investors as easily, and growth would have been hindered in the early years.  For this reason, understanding your current business form and its benefits and drawbacks is one of the best things you can do for your business.

If you'd like to learn what successful restaurant owners know about accounting, download our free report, "How to Avoid the 5 Pitfalls of Restaurant Accounting." Be on your way to becoming an expert on your business's accounting and have confidence in your accounting decisions. 

Author: Anne Gannon, founder and principal of The Largo Group.