In the very early stages of your company, you need to make a key decision: what type of business entity to form. Startup owners wondering whether to become a C-Corporation, an S-Corporation, or an LLC, regularly approach us. This is the most important decision a startup can make, because it will greatly impact the ability to raise investment money, impacting the future direction of the company. Your choice will have an immediate impact on your company, as well as lasting implications for your fundraising ability, especially if you decide to pursue venture capital.
1. Shields entrepreneurs from personal liability
2. Venture capitalists do not like to invest in “pass-through entities” such as LLCs or S-Corps for tax purposes
3. Flexible stock structure/easy to issue different classes of stock, also easy for investors to use different financial documents (i.e. convertible notes, SAFES, warrants, subordinated debt)
4. Best structure to raise equity capital through crowd funding sites like “Kickstarter”
5. Maximize medical coverage tax deduction
6. Minimize employment taxes (Shareholders and employees C-Corps pay Social Security and Medicare taxes only on wages they receive)
7. Eligible for dividends received deduction
8. Easier to get foreign investors (S corporations and LLCs cannot have nonresident shareholders.)
Why Venture Capitalists prefer to invest in C-Corps to S-Corps and LLCs:
All men may be created equally, but not all corporations are created equally. If you’re torn between setting your company up as an S-Corp or a C-Corp, it’s worth noting that VC’s vastly prefer C-Corporations to S-Corporations and LLCs. Here’s why:
LLCs and S-Corps present tax problems:
An LLC can pick which tax treatments apply, whether it is a sole proprietor, a partnership, a C-corporation, or an S-corporation. An LLC has the option to opt out of the default treatment (one owner is treated for tax purposes in the same way that the owner of the LLC, two or more owners are considered a partnership by electing to be treated as a corporation instead). After electing to be treated as a corporation, owners of an LLC can further elect to be treated as an S-corporation. This allows S-Corporations to avoid double taxation on the corporate income. Like LLCs, S-Corps are “pass-through” entities, meaning that it reports corporate profits and losses are passing through the shareholder’s personal tax returns and are assessed tax at their individual income tax rates. Furthermore, the S-Corp doesn’t pay federal income tax, instead the S-Corp’s shareholders pay federal income tax on the company’s taxable income, based on their pro-rated stock ownership. Venture Capitalists simply don’t want to deal with this sort of complexity.
Most Venture Capital firms cannot legally be shareholders in LLCs orS-Corporations
In jurisprudence, a “natural person” is a human being, as opposed to a legal person (i.e. a business entity). To legally invest in an S-Corp or LLC, shareholders must be U.S. citizens or residents and “natural persons.” This legality rules out foreign investors, as well as much domestic venture capital money. Venture capital firms are not “natural persons.” To complicate things further, firms with tax-exempt partners cannot legally invest into either S-Corps or LLCs because they are pass-through entities. Since C-corporation’s income does not flow through to its shareholders, C-corps are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxable income that passes through to them.
Only C-Corps can offer “preferred stock”:
Corporations can offer two classes of stock: common and preferred. Unlike common stock, issuing preferred stock lets you decide which features you want to incorporate into the offering. S-Corps and LLCs can only offer common stock, not preferred stock. Preferred stocks are more appealing to VC’s because they pay higher dividends and put stockholders first in line to get paid out in the event of liquidation. Preferred stock is a way for VC’s to ensure their safety while taking a significant risk on your company.
Limitations on growth:
The term “S corporation” means a “small business corporation” which under § 1362(a), means it is limited to only 100 shareholders. Although this may sound like a lot for a startup that has yet to issue a single stock, this upper limit can be reached rather quickly (especially with distribution of employee stocks). VC’s often worry about a startup’s inability to grow once the 100-shareholder threshold has been reached. C-corporations have no limit on the type or number of shareholders a C corporation may have.
Making the switch:
If you are currently an LLC or an S-Corp and want to pursue venture capital, you need to be ready to make the switch. The process is not simple; it will cost you time and money, and you’ll need a savvy lawyer to guide you through the process. As experienced New York corporate and startup attorneys, we can relate. We are entrepreneurs, too. At Fisher Law Group, we understand the complexities of business transactions; let us help you navigate through the complicated legal landscape.