URL Structure for Directory Site

[knowyourbank]

We have a directory that we're building and we're not sure if we should try to make each page an extension of the root domain or utilize sub-directories as users narrow down their selection. What is the best practice here for maximizing your SERP authority?

Choice #1 - Hyphenated Architecture (no sub-folders):

1. State Page /state/
2. City Page /city-state/
3. Business Page /business-city-state/
   4) Location Page  /locationname-city-state/

or....

Choice #2 - Using sub-folders on drill down:

1. State Page /state/
2. City Page /state/city
3. Business Page /state/city/business/
   4) Location Page  /locationname-city-state/

Again, just to clarify, I need help in determining what the best methodology is for achieving the greatest SEO benefits. Just by looking it would seem that choice #1 would work better because the URL's are very clear and SEF. But, at the same time it may be less intuitive for search. I'm not sure.

What do you think?

[MassivePrime]

Word Separators
Avoid hyphens. Hyphens detract from credibility and can act as a spam indicator. (This is a direct quote from the SEOMoz blog)

Also, Google webmaster tools lets you set geo-location preferences to sub directories. You can do this by creating  a new "site" listing in google webmaster central that also includes the subdirectory, so in addition to having a www.domain.com listing you would create an additional listing for www.domain.com/it (Italy) or www.domain.com/uk (for the UK) and then set the geo location accordingly. When you're creating backlinks and tracking traffic it's logical to do it per location when you are running a directory so that's another argument in favour of sub-directories.

Sub directories are standard practice, however I should mention that if you are aiming for user generated content in this directory and if the topics are broadly varied then you should also consider sub domains. Separating user generated content into its own subdomain allows Panda to penalize low-quality content and leaves the quality content untouched.

Hope this helps