Why do Venture Capitalists Prefer to Invest in Corporations?
With the rise in formation of limited liability companies (LLC), why do venture capitalists (VC) still prefer to invest in corporations? This is a common question within the startup community. With so many choices—partnership, LLC, S corporation (S corp), C corporation (C corp), etc.—it can be a challenging task to pin down exactly what form of legal entity to choose for your new business. However, if your business plan is dependent on seeking VC funding, your entity choice can be narrowed down to one: the C Corp. Today’s post details the most important reasons why venture capitalists prefer to invest in corporations.
Stock and Shareholder Restrictions
One benefit to a C corporation is that it allows for two or more classes of stock (Common and Preferred). In contrast, S corps are limited to one class of stock, shareholders must be U.S. citizens or residents and “natural persons,” and the number of shareholders cannot exceed 100. Generally, VCs will demand preferred stock in return for their investment. Most VC firms are organized as partnerships or LLCs, which are not “natural persons.” Therefore, many VC firms are precluded from investing in an S corp. As a company grows, the limitation of 100 shareholders can become problematic. As more stock is issued to employees (often in the form of stock options), you can reach the 100 shareholder threshold quicker than you might expect. VCs may worry that the growth of the company may be stunted by such a restriction on the number of shareholders.
Stock Option Plans
A corporation can hand out stock options or incentive stock options, allowing for equity to be issued as incentive compensation to employees, directors, and outside service providers. This is often important to VCs since the growth, sustainability and, ultimately, the profitability of the company may depend on its ability to attract high-quality executives. While LLCs can provide equity compensation in form of a “profits interest,” they cannot provide stock options or incentive stock options to their employees. There are extensive tax regulations that govern providing a member with a “profits interest” in an LLC. Stock options are much easier to provide to an employee of a corporation.
Transferability of Equity
Membership interests in an LLC are typically not freely transferable by state statute. Depending on the state statute and the LLC operating agreement, it is often more of a hassle to transfer or sell an interest in an LLC than a corporation. If an IPO is a foreseeable exit strategy for a venture capital funded company, trading shares in a corporation is far easier than trading membership interests in an LLC.
Pass Through Taxation
One benefit (for everyone but a VC) of LLCs is pass through taxation. However, VCs do not want pass through taxation because they don’t want the accounting and tax matters of a funded company to be passed down to the VC firm. Once the funded company’s taxes are passed through to the VC firm, the taxes may be attributed to the VC’s tax exempt and foreign limited partners. The tax exempt partners may have to recognize “unrelated business taxable income” (UBTI) issues and the foreign partners may be required to file U.S. tax returns if they are deemed to be “doing business” in the U.S. as a result of the pass through tax consequences.
Longer History Equals More Predictability
LLCs are a relatively new type of legal entity. The first LLC act appeared in Wyoming in 1977, and it was only in the last decade or so that LLCs became increasingly popular. Thus, there isn’t a well developed set of rules or regulations for LLCs, nor is there an extensive history of case law and precedent. On the other hand, corporations provide a higher degree of predictability with regards to corporate governance and shareholder rights.
This is by no means an exhaustive list of the reasons why venture capitalists prefer to invest in corporations. However, we believe the issues noted above are some of the more notable reasons a corporation that are attractive to venture capitalists. Until (and unless) your business plan is dependent on seeking venture capital investment, forming your business as an LLC offers a wide range of flexibility including a rather simple conversion to a C corporation if you decide to seek VC funding later.