Natural Entrepreneur: Consider Your Exit Strategy

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Consider Your Exit Strategy

When forming your business, look to the end game

-- by Matt Benson, Cook, Little, Rosenblatt & Manson, p.l.l.c., Manchester, NH

In a previous article, I discussed taxation as a consideration when deciding your busienss entity. In this article we look at how your exit strategy impacts this decision as well.

An important consideration for an entrepreneur is the nature of the business and the entrepreneur’s exit strategy. If the entrepreneur intends to grow the business relatively slowly and intends for the business to provide long-term employment for the entrepreneur, then the business is considered a “lifestyle business”. If the entrepreneur instead intends to grow the business more quickly to make it attractive to potential buyers (or in very rare cases, for an IPO), then the company will be more attractive to outside investors.

If the business is intended to be a lifestyle business, then the exit strategy and investor preferences are not significant considerations. While an entrepreneur starting a lifestyle business still has important decisions to make regarding the type of entity, other factors will determine the type of entity to be formed.

If the entrepreneur intends to grow quickly by seeking outside investment, then the preferences and expectations of investors become very important. If the initial investment is expected from private individuals, those investors may prefer pass-through tax treatment to take advantage of the initial tax losses that the business is likely to generate. As mentioned earlier, this can be accomplished through the use of entities such as a limited liability company or a S corporation.

However, if (as is often the case) the investors demand preferences on their ownership interests (such as liquidation preferences, dividends, put rights, affirmative and negative controls over certain decisions, etc.), this generally requires that there be more than one class of stock. Thus, an S corporation is not an option because of the prohibition on more than one class of stock.

If it is expected that the initial investment dollars will be sought from an institutional investor, such as a venture capital (VC) fund, then a C corporation will generally be the entity of choice as institutional investors typically do not want pass-through tax treatment. Likewise, if an initial round of investment from individuals is expected to be followed shortly by an institutional round, then the advantages of pass-through tax treatment may be offset by the effort and expense of converting to a C corporation before the institutional investment is made.

This is the second in a series of articles on your decision of business formation entity.

Matthew Benson is an attorney with Cook, Little, Rosenblatt & Manson in Manchester, NH. He can be reached at (603) 621- 7115 or via email at mbenson@clrm.com

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