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3. ENTITY FORMATION

b. Type of Entity

The next step is to consider creating a formal legal entity for your new management company or fund. Fund management companies are usually organized as "S corporations" or limited liability companies (LLC's), and private equity funds are usually organized as LLC's or limited partnerships (LP's).

Overview

Business entities are creatures of state law. If your entity will register or do business in California, you should use an entity type that is recognized by California law. California law recognizes the following types of entities:

• sole proprietorship
• general partnership
• limited liability partnership
• limited partnership
• limited liability company
• general corporation
• professional corporation
• other types

Other Types

The “other types” include unincorporated association, common interest development association, and additional types. These types are generally inapplicable to the business of private equity, and this publication will not discuss them further.

Sole Proprietorships and General Partnerships

Sole proprietorships and general partnerships are not formal entities. You create those entities informally, merely by doing business on your own or with others. You do not need to file anything with the state to create the entities.

However, without the protection of a formal entity, the owners of sole proprietorships and general partnerships are exposed to the risk of unlimited personal liability for the debts and obligations of their companies. General partnerships are especially risky because the partners have “joint and several” liability, meaning that each partner is responsible for 100% of the debts and obligations of their partnership.

If you want to limit the liability exposure of the owners, choose an alternative type of entity.

Professional Entities

A “professional corporation” is a type of corporation available only to certain types of licensed professionals. A “limited liability partnership” is a type of partnership available in California only to attorneys, accountants, and architects. Neither of these types of entities are available to fund management companies or their private equity funds.

General Corporations

A “corporation” is the classic form of business entity. The owners of a corporation are called “shareholders” and own shares of company “stock”. Shareholders have limited liability, which means that they are generally responsible only for making initial contributions of capital in exchange for stock.

California law imposes many requirements on corporations. Typically, every corporation must have a board of directors. The directors are elected by the shareholders at annual meetings. The meetings must comply with various rules regarding notices, votes, and other matters. In addition, every corporation must have the following officers: chief executive officer/president, secretary, and chief financial officer/treasurer. The same person may occupy more than one office. The officers are appointed and removed by the directors. The law does not require director meetings, but directors typically meet on a quarterly or annual basis.

Many of the legal requirements are non-waivable. However, a corporation with fewer than 36 shareholders can avoid several of the formalities by electing “close corporation” status and executing a shareholders' agreement that specifies different rules. The “close corporation” designation applies only to the state level and has no consequences at the federal level.

At the federal level, federal tax law divides all for-profit corporations into two categories: “C corporations” and “S corporations”. C corporations are the traditional form. In this form, company income is taxed twice – first at the company level, then at the shareholder level. This is the problem of “double taxation”. Some corporations can largely avoid double taxation by electing “S corporation” status. S corporations are taxed as partnerships, meaning they are “pass through” entities where company income is taxed only once, at the shareholder level (except with regard to certain capital gains and passive income). Although largely exempt from federal income tax, S corporations remain liable for employment and excise taxes.

Not every corporation can elect “S corporation” status. The primary limitations are:

• organized in the United States
• maximum of 100 shareholders
• shareholders may not be foreign citizens residing abroad
• shareholders may not be business entities
• no special allocations of gains and losses among the shareholders
• only one class of shares

The “one class of shares” requirement refers only to economic rights, not governance rights. Economic rights are the rights to share in profits and losses (“profits interest”), and receive distributions of assets upon liquidation (“capital interest”). Governance rights are the rights to vote, participate in management, and receive information from the company. Thus, an S corporation cannot have two or more classes of shares unless the classes differ by governance rights only.

The "S corporation" type may be appropriate for a fund management company. However, due to its limitations, the "S corporation" type is usually not appropriate for a private equity fund.

To avoid the limitations of an S corporation and the “double taxation” problem, consider the limited partnership (LP) and limited liability company (LLC) options. Like S corporations, the LP and LLC types are “pass through” entities taxed as partnerships (unless they elect to be taxed as corporations, which seems unlikely). Unlike S corporations, the LP and LLC types avoid many of the formalities imposed by California law on corporations.

Limited Partnerships

The “limited partnership” type evolved from the general partnership type. A limited partnership must have at least one general partner and one limited partner. The general partner manages the business and has unlimited liability for the debts and obligations of the entire limited partnership. If the limited partners do not participate in management, they have limited liability and are thus analogous to shareholders of a corporation. A board of directors is optional.

The general and limited partners own “partnership interests” of the entity. The term “partnership interests” is analogous to the “shares” of a corporation. None of the limitations of S corporations apply to limited partnerships.

The LP form is usually not appropriate for a fund management company. However, private equity funds were historically organized as LP's, and the LP form continues to remain popular for such funds.

In the case of a private equity fund organized as an LP, the fund management company is the general partner and the investors are the limited partners. The individual managers of the fund usually operate through a fund management company in order to limit their liability exposure.

Limited Liability Companies

The “limited liability company” type is the successor to the limited partnership type. As noted above, a limited partnership needs at least two owners (one general partner and one limited partner), and the general partner has unlimited liability. The LLC form avoids these problems by requiring only one owner and limiting the liability of every owner.

Each owner of an LLC is called a “member”. The LLC is managed by one or more of the members, or by a non-member appointed by the members. Alternatively, the members may delegate the appointment authority to a board of directors. A board of directors is optional.

Typically, all members of an LLC own “membership interests”. None of the S corporation limitations apply to limited liability companies.

The LLC form is a popular choice for fund management companies and private equity funds. In the case of a private equity fund organized as an LLC, the fund management company is both a "member" and the "manager", and the investors are non-managing members.