Corporate Finance & Securities

Why C Corporations are the Preferred Entity for Tech Startups

Generally, tech startups that hope to scale and become the next Amazon or Twitter are going to seek capital from angel investors and venture capitalists. This extra capital will likely be necessary to enable your business to hire engineers and build the foundation for your company to take off.Zuckerberg Startup School

Angel investors and venture capitalists generally don’t want to be part of an LLC, and you probably wouldn’t want them to be a member of your LLC. These investors have day jobs or identify startup talent for a living, so they do not want to be overly burdened with the day to day affairs of a new startup. They are generally passive investors.

This entire discussion presupposes that we’re talking about the default setup of LLCs. LLCs are a very flexible entity and could be arranged to have most of the benefits of a C corporation. At the conclusion of this article we’ll briefly discuss how LLCs could be setup as a C corporation, and why they’re usually not.

Why the C Corporation is Ideal for Passive Investors

No pass-through tax

C corporations do not have pass-through taxation. Investors don’t like pass through taxation, because it can result in a tax bill for the investor, even if the investor receives no distributions from the company. S corporations and LLCs are not taxed as entities, meaning the owners of the entities are responsible for paying tax on the company’s income. So, if an LLC has a profit of $1 million dollars, and it decides to keep all that money as retained earnings to be invested in the company in the next few years (as startups almost always plan), a 10% shareholder would have $100,000 in pass-through income to pay tax on–even if the company does not distribute a dime to the shareholder. While this concern can be mitigated to some extent by the check the box rules, the IRS will always win if there is a mix up, so the C corp makes investors less anxious.

Corporate government structure for passive investors

The corporate government structure is perfect for passive investors like angel investors and venture capitalists. They generally don’t want to be involved in day to day hiring decisions, marketing strategy, and other day to day activity. In a corporation, the shareholders influence corporate activity by electing directors who, in turn, elect corporate officers to run the daily affairs of the business. This can be contrasted with an LLC or partnership where the members or partners usually all have a say in the day to day activities of the company, or are only one step removed from day to day affairs. While many investors join the board as a director and maintain a single step removed from day to day activity, having the option to influence company affairs less directly using well established rules is particularly compelling for some types of angel and venture capital investors.

Easier to Grant Employees Equity

Most tech startups want to have stock options for their employees. It’s generally much easier to put together an employee stock option plan for a corporation than it is for an LLC. It’s easy enough to issue units of an LLC to employees (units are to LLCs what shares of stock are to corporations), but the tax consequences and regulatory issues are much more complex when issuing units of an entity taxed as a partnership as opposed to issuing stock of a corporation.

Easier to Give Preferred Rights to Investors

Most VCs want preferred stock. Putting together documents for multiple classes of stock is generally easier than putting together documents enabling different classes of LLC or partnership interests. Also, S corporations are only permitted to have one class of stock, so the S corp is not an option for entities that have preferred shares (although you can be an S corporation and convert to a C corporation when you want to issue preferred shares).

Tax

 

Dividends not Subject to Self Employment Taxes

Say your tech startup takes off and you want to take out $500,000 from your company. If you have an LLC (assuming that the LLC hasn’t elected to be taxed as a corporation) you have to pay ordinary income tax on all that money. But if you have a corporation, you would only have to pay ordinary income tax in an amount equivalent to a reasonable salary, and you could pay the lower capital gains tax rate for any distributions beyond a reasonable salary.

Familiarity with C Corporation Structure

Investors and seasoned entrepreneurs have experience working with C corporations. Each entity has it’s own quirks and jargon. For example, an LLC’s governing documents are called an operating agreement, while a corporation’s governing documents are called bylaws. The familiarity with the governance and taxation of C corporations is such a large benefit for investors that most wouldn’t seriously consider investing in any other type of entity.

Returning to our initial assumption that we’re discussing LLCs as they are ordinarily set up, we should point out that LLCs can be taxed as C corporations by filing a simple election with IRS. LLCs can also be set up to be run by a board of directors nominated by the members of the LLC. But LLCs usually aren’t set up like corporations, because if you want a business with the structure of a corporation, it’s generally easier (and less expensive) to just form a corporation instead of an LLC. And even if you operated an LLC exactly like a corporation from a tax and governance perspective, given investors’ familiarity and comfort with corporations, you still would not be as well off.

Thanks for reading. If you want advice on what type of entity would be best for your tech startup, please comment below or contact us today.

Photo: Robbie Scoble | Flickr
Photo: 401k(2012) | Flickr

        


Kyle Hulten

When I'm not in the office I enjoy cooking, gardening, and watching my toddler son explore his little universe.


146 N Canal Street, Suite 350   |   team@invigorlaw.com